Summer squall brewing

Bottom line

As we approach the midpoint of a choppy equity market thus far in 2026, we are reminded of two of our favorite investment platitudes: philosopher George Santayana’s “Those who cannot remember the past are condemned to repeat it” and economist John Maynard Keynes’ “Markets can remain irrational longer than you can remain solvent.”

These sayings both apply to 2026, in which a leadership transition at the Federal Reserve takes place within a midterm election year. That has happened only six times in the past 92 years. The US equity market’s behavior in this admittedly small sample size was a solid rally to start the year, a summer correction that shaved nearly 15% from the averages during the second and third quarters, and then a powerful year-end rebound that drove stocks to new record highs. With this past as prologue, let’s explore their potential path for the balance of 2026.

It’s (still) all about Iran February and March were difficult months for equity investors. Spurred by the US and Israel attacks on Iran on February 28, the S&P 500 and the Nasdaq Composite declined around 10% and 14%, respectively. Crude oil prices (West Texas Intermediate, or WTI) spiked more than 84% to almost $120 per barrel by March 9, while gasoline prices leapt nearly 54% to an eventual peak of $4.56 per gallon on May 20. But with a fragile ceasefire and peace negotiations providing some optimism, equity investors have been discounting the war’s conclusion since the end of March. The S&P rallied more than 20%, marking a record high at just under 7,621 on June 2; the Nasdaq surged nearly 32% to a new high of 27,190 on June 1.

What drove shares higher? In a word, oil. WTI prices have plunged nearly 43% from their recent peak to $69 today and nationwide average prices at the pump dropped 15% to $3.90 per gallon today. The S&P's first quarter earnings season was outstanding, with stronger-than-expected revenue and earnings per share growth of 11.9% and 28.8% year-over-year (y/y), respectively. Net profit margins have increased 14.8% y/y, and seven of the 11 S&P sectors have posted double-digit earnings gains, paced by 50% increases in Technology and Communications Services.

Stocks always test a new Fed Chair The shift from Jerome Powell to Kevin Warsh is now complete. At his first Federal Open Market Committee (FOMC) meeting last week, the Fed opted to keep interest rates unchanged and the markets were sanguine. But in the 11 previous transitions over the last 93 years, the equity market has tested the new head in the first year in office. After a honeymoon rally of a few months, the S&P declined by an average of 14% (and a median drawdown of about 10%) over the next two quarters. But stocks eventually rebounded to new record highs by year-end. The current transition may prove to be more volatile:

• Warsh’s Senate confirmation hearing was highly contentious and the vote the narrowest in history, with only one Democrat (John Fetterman, Pa.) in favor. That was disappointing to us, as Warsh is eminently qualified. He served as a member of the Fed’s Board of Governors from 2006 to 2011 under Presidents Bush and Obama, and he played an instrumental role in helping the economy and financial markets recover from the Global Financial Crisis. 
• For only the second time in the Fed’s 113-year history, the previous chair decided to remain on the board after the term as chair expired. Powell's chairmanship ended May 15, but he can sit on the board until January 2028. That may create confusion for the other members of the Board of Governors and the 12 regional Fed presidents, as Warsh begins to put his stamp on the Fed.
• In Powell’s last FOMC meeting on April 29, four voters dissented — the most since 1992 — from the decision to hold rates at 3.50-3.75%. One of those, Governor Stephen Miran, has since left. But three regional presidents wanted to remove the language of the meeting’s policy statement that had a bias toward easing. That bipartisan step came to pass in last week’s meeting. Warsh stirred the pot by announcing five task forces to orchestrate changes at the Fed. He likely will provide more details when he delivers the keynote speech at the Fed’s annual monetary policy symposium at Jackson Hole, Wyo., in August. So, there’s ample opportunity for the financial markets to be disenchanted with the early stages of his tenure.

Dual mandate dilemma A critical question is how Warsh will navigate the Fed’s Phillips Curve tradeoff between the labor market and inflation. Over the past three months, US employment has improved, which seemingly takes a rate cut off the table. But inflation has spiked from a five-year low to a three-year high over the past three months, largely following the temporary spike in energy. The Fed appears willing to look through the fog of the Iran war and avoid hiking rates, recognizing that inflation should begin to trend lower if energy prices continue to decline. But the conflict could heat up again, and the Fed might hike rates anyway. All of this will have a profound effect on financial markets.

Midterm election years can be perilous Over the past 80 years, the chart of stock prices consistently rose up and to the right, largely reflecting the growth of the US economy and corporate earnings. But a look at the Presidential election cycle is revealing. Breaking these four-year periods into quarters shows that the S&P has been consistently positive in 14 of those 16 quarters. The negative two have always been the two middle quarters of the midterm election year.

Political pendulum in Washington tends to impact stock prices Why does this happen? In the 23 midterm Congressional elections from FDR in 1934 through Joe Biden in 2022, the party out of power (currently the Democrats) regains an average of 27 seats in the House of Representatives. With the Republicans having only a five-seat lead, legislative control of Congress may soon change, especially as President Trump’s approval ratings on key issues are underwater, particularly inflation and the Iran war.

Investors do not like to switch horses midstream Stocks prices hit record highs this month, and investors are loathe to change Washington leadership if the economy, corporate profits and stock prices are all strong. Faced with the prospect of uncertain midterm elections, investors might again lock in profits made in the second and third quarters. According to Strategas, the average market drawdown in all midterm election years from 1962 to the present is 19.4% (within a range of 38% to 7%).

Historically, in the fourth quarter following the primaries, when they have a good sense of how the next Congress will vote, investors begin to put money back into stocks. The reasoning is that fiscal policy will benefit from the new legislative check-and-balance caused by the divided government. From the trough of the S&P 500 during the midterm election years, stocks then typically rallied into year-end and through years three and four of the presidential election cycle. Opportunistically picking off the bottom that stocks hit in year two and patiently holding them to the year four peak has historically been a profitable strategy, with rallies that approximate 40-50%.

Halloween indicator We are amazed that the equity market continues to follow the popular and long-lived (80-plus years) maxim of “Sell in May and go away.” That’s because the six summer months from May through around Halloween historically underperform the six winter months from November through April by an average of 4.6 percentage points annually.

Buy the dips Putting together the confluence of the Fed’s leadership transition, the midterm election year and the Halloween indicator, we believe there is a high likelihood of a 10-15% air pocket occurring within the June to October period this year. The situation is exacerbated by the uncertainty of the Iran war’s impact on energy prices and inflation. So, it might be best for equity investors to play defense now. We expect the opportunity to get the offense back on the field will arrive later this year.

Read more about our views and positioning at Capital Markets.

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