The S&P 500 index has recorded a substantial advance of 16% during 2025, which marks the third year in a row where gains have exceeded 10%. This continuous stretch of growth is notable, yet industry observers and historical data suggest that this pattern may not extend uninterrupted into 2026. Traditionally, midterm election years have presented more challenging environments for equity investors, compounded this time by valuations that stand high relative to historical measures.
Federal Reserve Chairman Jerome Powell highlighted these valuation concerns in September by noting that, "By many measures... equity prices are fairly highly valued." Despite this warning, the S&P 500 continued its upward trajectory, pushing valuations further. Presently, the index exhibits one of the highest price tags recorded in its history, raising questions about sustainability.
Historical Midterm Election Year Performance
Since its inception in 1957, the S&P 500 has experienced 17 midterm election cycles. During these years, the index's average return has been approximately 1%, excluding dividends. This figure contrasts sharply with the broader annual average return of 9% over the same multi-decade span. More notably, when a new president is in office, midterm years have generally been tougher on equities, with average declines of around 7% observed.
Much of this hesitance stems from the political uncertainty midterm elections often generate. Historically, the president’s party tends to lose seats in Congress during these contests, which injects risk into the market by obscuring future policy directions. This ambiguity can deter investors, as it complicates forecasts for economic and regulatory frameworks. As a result, the market commonly reacts with caution, manifesting in reduced prices or volatility as investors reassess risk exposure.
However, this phase of uncertainty tends to resolve quickly. Research by Carson Investment Research illustrates that the six months following the midterm elections—encompassing November through April—have traditionally been the most fruitful segment of the presidential term, with average returns of about 14% during this interval.
Federal Reserve Officials Highlight Elevated Equity Valuations
Jerome Powell's cautionary remarks are echoed by other Federal Reserve officials. According to minutes from the October Federal Open Market Committee (FOMC) meeting, several participants expressed concern that asset prices were stretched beyond sustainable levels in financial markets. Some specifically warned of the risk of a "disorderly fall in equity prices."
Adding to this perspective, Fed Governor Lisa Cook remarked in November about an increased probability of significant asset price declines. She referenced the Federal Reserve's latest Financial Stability Report, which identified the forward price-to-earnings (PE) ratio of the S&P 500 as nearing the upper bound of its historical range.
Currently, the S&P 500's forward PE stands at 22.2, a notable premium compared to its 10-year average of 18.7, according to data compiled by Yardeni Research. Historically, the index has only surpassed a forward PE multiple of 22 on three occasions, each followed by steep downturns.
Historical Examples of High Forward PE and Subsequent Declines
- Dot-com Bubble (Late 1990s to Early 2000s): During the late 1990s, exuberance around internet-based companies drove the forward PE above 22. This speculative bubble burst, leading the S&P 500 to drop 49% from its peak by October 2002.
- COVID-19 Pandemic Period (2021-2022): The forward PE ratio again exceeded 22 in 2021 as the market underestimated inflation sparked by pandemic-induced supply chain disruptions and stimulus measures. This period culminated in a 25% decline in the index from its high by October 2022.
- Post-2024 Election Period: In 2024, the forward PE rose above 22 amid optimistic investor sentiment following President Trump's reelection. However, the market did not fully incorporate the implications of new tariff policies, and the index declined 19% by April 2025.
Implications for Investors Heading into 2026
While surpassing a 22 forward PE multiple does not guarantee an imminent crash, all historical instances of such valuation extremes have been followed by substantial market pullbacks. When combined with the typical stock market struggles during midterm election years, these factors suggest a cautious outlook for the S&P 500 in 2026.
Investors should be aware that the intersection of high valuations and political uncertainty creates conditions prone to market corrections or increased volatility. Nevertheless, the potential for recovery and strong returns in the aftermath of the midterms remains, as evidenced by past cycles.
This comprehensive overview highlights the nexus between valuation metrics and political cycles impacting the stock market, suggesting prudent evaluation by market participants as 2026 approaches.