This Market Signal Has Been 95% Accurate for Nearly 90 Years. What Investors Need to Do Now to be Ready

Key Points

• Investing in stocks in the third year of an election cycle has proven to be a great bet.
• The market has historically staged strong rallies from October through December.
• 10 stocks we like better than S&P 500 Index ›

One of the best predictors of stock market performance over the past nearly 90 years isn't some fancy valuation metric, like the Shiller cyclically adjusted price-to-earnings (CAPE) ratio or Buffett indicator. Nor is it some complex macroeconomic forecast or interest rate model. It's actually the midterm elections.

According to research by Fidelity, the S&P 500 (SNPINDEX: ^GSPC) has had a positive performance one year after the midterm elections 95% of the time since 1938. The best thing is that it hasn't mattered which party wins, or whether the incumbents or challengers take more seats. The reason for this appears to be that the political uncertainty heading into the election fades after the votes are tallied.

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The market tends to dislike uncertainty and has generally taken a shoot-now-ask-questions-later mentality to major events. As such, it does make sense that once some of the uncertainty is lifted, stocks tend to outperform. In fact, not only have stocks gone up 95% of the time following midterm elections from November to November, but this is also historically the best year of returns in the election cycle. Since 1950, stocks have generated an average annual return of 14.5% during year three of a presidential cycle, which comes after the midterm elections.

Ironically, the next-best period since 1950 is year four, with a 9.1% average annual return and a 72% chance the market goes up. However, year four is also the most unpredictable year, with the S&P 500 experiencing both large gains and losses.

Year two of the cycle, meanwhile, tends to be the worst year for stocks, with an average return of 4.9% and only a 55% chance of a 12-month positive return since 1950. The September right ahead of the midterms tends to be a particularly tough stretch. According to Cantor Fitzgerald, the market has dropped in September by 5% or more in 15 of the past 24 midterm election years since 1930.

However, Carson Group has noted that since 1950, October and November have been the best months for stocks during midterm election years, up 3% and 2.7%, respectively. UBS, meanwhile, has noted that during midterm election years, the market has rallied about 6% from the end of September through year-end.

How should investors prepare?

First, it would be foolish not to note that past patterns and historical performance are no guarantee of future outcomes. While a pattern clearly exists, from a statistical standpoint, the sample size would still be considered very small.

That said, given this pattern and the current bull market, I think investors need to be invested. There has been a lot of talk this year about an AI bubble and a potential market crash, but this is not a time to sit on the sidelines. Yes, some valuation metrics like the CAPE ratio and Buffett indicator suggest that the S&P 500's market valuation is high, but the index's makeup is very different today than in the past.

Gone are the days when the index was led by cyclical industrials, energy companies, and financials. Today, the S&P is dominated by large tech companies with less cyclical businesses, huge operating cash flow generation, great balance sheets, and strong growth prospects. Meanwhile, artificial intelligence (AI) has also changed the game, and the innovation curve is only getting steeper, meaning new technologies are being developed much more quickly than in the past. Unlike past tech innovation cycles, like PCs, the internet, and smartphones, AI growth is also not bound by human usage -- it's essentially limitless.

As such, I'd be investing in some top exchange-traded funds (ETFs), like the Vanguard S&P 500 ETF (NYSEMKT: VOO) and Invesco QQQ Trust (NASDAQ: QQQ), which tracks the tech-heavy Nasdaq-100 index. These are quick and easy ways to invest, and both can be used as solid core holdings. Investors can then supplement those core holdings with some attractive growth stocks.

With September coming to a close, now is the time to jump into the market.

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Geoffrey Seiler has positions in Invesco QQQ Trust and Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.