Valentine’s Day is behind us, and it is clear (in the stock market) who got the chocolates and who got no love. The technology group and most specifically the software sector got no love and has been in a decline since around November. To many this is a reflection of the market’s lack of confidence in continued outperformance. In making a topical observation, AI has had an immediate effect on business in general and as a result a sort of earthquake effect on parts of the software sector that virtually every industry is dependent on.
In evaluating the technology group, I believe that there is a clear separation that has evolved from this move. To assess relative AI risks and its impact on each industry, I have separated the effect into three different categories:
- Replacement- AI could substitute for some or all of the features provided by a certain type of software.
- Coexist- AI and software can operate alongside each other and be mutually beneficial. Adding a catalyst benefit to the user of both.
- Enhance- AI is likely to increase demand for the software stack and give a company a chance to really turbo-charge its business and profitability by simply using an AI overlay.
In many cases the lines between these three are blurred and will morph and change over time. In the end, it is clear that AI is here to stay, and even though there are many negative repercussions of its implementation, overall, it has been and will be very progressive.
In taking a look at the economy briefly, it is clear that we are still deeply ingrained in an economic expansion. Not only that, but an expansion that collectively has not been inflationary. This is a Goldilocks situation for sure. I believe this is why there has been a continued rise in the overall equity markets throughout the world and most specifically a level of “catch up” being seen by the majority of industries that have not been the leaders post COVID. Will this continue? Well, as a market participant, it will continue until it doesn’t, or until the catch up from non-technology companies has run its course and it will be time for these industries to take a breather as well. Until this happens, the move must be respected as real. These kinds of shifts tend to be quite violent and attention getting, yet the reasons why a particular industry should continue to be held should be based on long-term analysis of broad economic moves.
The bigger issue at hand, from a longer-term perspective is that of what a midterm year looks like and how this midterm years is beginning. Strange as it may seem, every time is a bit different, yet almost every time markets seem to do the same thing! This will be the bulk of what I plan on discussing in this week’s note.
Midterms are notorious
For a few reasons midterms are notorious. Politically, voters have turned against the party in power. Pundits explain the poor performance on a failure to deliver on campaign promises or the public’s general dissatisfaction with whomever is guiding the ship. In the case of President Trump, his style is really so different that it has created a very polarizing environment between voters, friends, and families. Is this a good or a bad thing? I believe it is good as it shows that people are paying attention, but it is a bad thing in that people are at odds and not paying attention to the fact that the overall economy is flourishing, and this is really what we hired him to do. Of course, different parts of the government will act differently, and this is grounds for discussion, but I am speaking from a general perspective.
As investors and economic observers, we see midterms through a different lens. The stock market tends to perform poorly heading into midterm elections in the second year of a presidency. One reason is uncertainty around policy changes should control of one or both chambers of Congress flip parties. President Trump is attempting to buck this historical trend through a series of policy initiatives. Whether he and his team will be successful politically and economically should play a big role in how market perform in the coming months.
Besides President Trump pulling a (midterm) rabbit out of the hat, there are certain seasonal hurdles that need to really be overcome. These are both historical midterm market actions and also what changes in general government policy tends to have an effect.
The really interesting things that are prevalent “this time” are clearly economic strength, both real and accentuated by the use of AI and other technologies, and a pre-existing condition of US equity markets hitting new all-time highs just a little over a week ago. But the first major point that I want to cover is that of seasonal tendencies. If we are to look at Four-Year-Presidential-Cycles, 2026 is following normal tendencies just as previous action has been going all the way back to 1928. See the chart below. I have highlighted the very beginning which signifies the action through the second week of February.
Midterm years and Februarys tend to be unfriendly to markets. Midterm years are the weakest, historically, for stocks, whether one is to look at the stodgier Dow Industrials or the NASDAQ, since 1900 or just since World War II. The last time the S&P 500 posted a 20%+ return during a midterm year was in 1998. In most recent years there were many catalysts that led to a volatile midterm year, namely the around 20% draw down during the Russian Ruble Crisis and Long-Term Capital Management blowup. I bring these up as many will remember them, but it should be recognized that whatever the case, a 20% drawdown is the norm.
To get a bit more granular, weakness tends to be concentrated in the second and third quarters. This year could be quite similar as there is not only the normal seasonal but also the installation of a new Fed Chairman as I had discussed last week. The silver lining, as can be seen in the chart above is that after a stormy season in the markets, they seem to finish quite strong. Should earnings, inflation, and interest rates behave, this year could follow these same seasonal tendencies.
Another notable anomaly has been that the US has tended to underperform the rest of the world during the first seven months of midterm years. The US / Non-US ratio has roughly followed its presidential cycle over the last three years, including a peak shortly after the presidential election in January of last year, then a recovery into year end. See the annotated chart below:
The wild card as I see it, this year, is the action of President Trump. There has not been many as strong in opinion and action as Trump, and the stock market’s poor performance in midterm years can usually be linked to government policy. Politicians may claim that they do not manage the economy around elections, but history suggests otherwise. These issues tend to be the focal points of administrations going into midterms:
- Real Monetary & Fiscal Policy- is the Fed in a rate easing or tightening cycle (currently easing) and are they decreasing or increasing money supply (currently increasing bias)
- Federal Expenditures- is the Fed spending funds on social and politically visible causes or not? Stimulus from previous presidential election tends to be removed during post-election year. Trump seemed to get this out of the way very quickly, maybe to prepare for this midterm issue.
- Biggest Impact in the first half of the midterm year. The policy index tends to trough in July and accelerates from there.
See the Four-Year tendency and Ned Davis Research’s expectation for this cycle below:
A coin toss in this presidency is whether it is considered a new presidential term or a second term. Given the amount and number of changes during the Biden administration, I would believe it to be more of a first term type of situation. I certainly hope this to be true as the chart below shows. If it is considered a first term Republican Presidency it is much stronger. The second term has tended to be far less robust:
Putting all of this noise aside and just paying attention to the first chart in this report, regardless of party or term of president, the US stock market has tended to follow the midterm-year pattern of a choppy start of the year, weakness in Q2 & Q3, and a Q4 rally. To show what is expected by the FundStrat team, led by Thomas Lee, this is his chart of what to expect this year:
Update on “The Most Important Chart in the World”
I have had a few readers ask for an update on the S&P 500’s LONG-TERM chart that I have deemed “the most important chart in the world.” There hasn’t really been much to discuss since the upper line that the index broke above last year has not really been threatened again since November. It’s hard to provide an exact level for where that line sits currently, but it appears to be a hair short of 6600 when I zoom in on it. From a bigger picture standpoint, we really want that line to hold as support now, since a breakdown beneath it will start to increase the risks of a false breakout and acceleration lower. As I’ve mentioned, there is theoretically unlimited upside potential above this line since it represented the limit of the long-term stock market’s uptrend over the past 100 years or so before it was recently broken. The index hasn’t really taken advantage of that free path higher so far, but with no real resistance overhead the longer-term bull case has a clear technical tailwind as long as that upper line holds.
So, the real question becomes whether the pullback in RSI can correspond to another rally again in the broad index. Maybe so, but in which sectors and could it be that the international could still be retaining relative outperformance????
In closing, I want to again ask you to look at the first chart I shared with you in this note. Sort of a tug-o-war first part of the year, an attempted rally, a digestion (I believe due to the unknowns of a new Fed Chair and midterm elections) and then when it is clear that nothing much should have changed, then a continued rally into year end due to the strength of the underlying economy.
I don’t know what will be the action in the markets this year, but I do know that there is plenty on our plates that could point to a far more volatile year than we saw after the Tariff Tussle last year. Stay tuned!
- Ken South, Tower 68 Financial Advisors, Newport Beach
-
Get Ken's Weekly Market Commentary Delivered To Your Inbox!
Important Disclosures:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
Investing involves risks including possible loss of principal.
The Standard & Poor's 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The S&P 500 is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States. Indexes are unmanaged and cannot be invested in directly.
The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.
The Nasdaq-100 is a large-cap growth index. It includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization.
The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index. Indexes are unmanaged and cannot be invested in directly.
The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
Data sourced from Bloomberg (2025).
Stock investing includes risks, including fluctuating prices and loss of principal.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Bonds are subject to availability, change in price, call features and credit risk.
Government bonds are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
LPL Tracking #1066140