Solid start to the new year
But midterm elections and Fed leadership transition could spark volatility.
Bottom line
The first fortnight of 2026 has been fortuitous for equity investors, with the S&P 500 rallying 1.4%, as it approaches 7,000. Strong fundamentals have been driving the bus, as productivity is soaring, economic growth is accelerating, and inflation has moderated from a 40-year high in 2022 to a four-year low now.
The fourth quarter earnings season has just started, and the early results are running stronger than expected. Last year’s labor market struggles may be bottoming, with initial claims and layoffs boasting green shoots and with improved hiring of federal government workers, immigrants and less-educated workers. As a result, business and consumer confidence appear to be turning higher after a dispirited slog.
Not all peaches and cream But the balance of the year is unlikely to be this easy for investors, due to the confluence of two potentially significant hurdles. Federal Reserve Chair Jerome Powell’s term expires on May 15, and President Trump will soon nominate his choice to replace him. Historically, the stock market has greeted new Fed chairs skeptically, with a temporary air pocket during that first year.
In addition, 2026 is a midterm election year. Republicans currently have the narrowest House majority in a century at only five seats (218-213, with four open seats). In the post-war era, the party out of power regained an average of 25 seats, which would restore split government in Washington. Historically, the S&P performs poorly in the middle two quarters of the midterm election year, as investors become concerned about how the changing power dynamic in Washington will alter fiscal policy in the following year.
Only two presidents over the past 80 years enjoyed a gain in House seats in a midterm election – Bill Clinton in 1998 and George W. Bush in 2002. We can safely expect that President Trump will continue to launch a series of populist fiscal policy initiatives in an effort to buck that historical trend, with a much-anticipated speech at the World Economic Forum in Davos, Switzerland next week.
Two of the stock market’s most popular early-warning indicators may provide some clues as to how 2026 unfolds:
- ‘If Santa Claus should fail to call, bears may come to Broad & Wall’ The Stock Trader’s Almanac defines the so-called “Santa Claus Rally” as the last five trading days in December and the first two trading days in January. Over the past 56 years since 1969, the S&P has been positive over this seven-day period 42 times (75%) by an average of 1.2%. But this year’s results were negative for the third consecutive year, with a small decline of 0.11%. In the 14 years in which the Santa Claus indicator started the year in negative territory, it finished the year positive 71% of the time (10 of 14 observations).
- Positive results for ‘Early January Barometer’ Historically, as the first five trading days of January go, so goes the full year. Since 1950, Jeffrey and Yale Hirsch at the Stock Trader’s Almanac report that 70% of the time (53 out of 76 observations), the direction of the full year – up or down – is the same as that of the first five trading days of January. But when the first five trading days of the year are positive, the S&P has finished the year in positive territory 84% of the time (41 out of 49 observations). The S&P’s first five trading days of 2026 were positive by 1.11% (on a price-only basis), which typically augur well for positive full-year performance.
Midterm election years are choppy In the 19 midterm election years since 1950, the year started and ended in the same direction 67% of the time (6 out of 9 observations). But when the S&P 500 started the year in positive territory, as it did this year, it also ended the year in positive territory only 55% of the time (6 out of 11 observations), which suggests that ensuing political developments during the year may have subsequently soured investor sentiment.
Fundamentals matter most Federated Hermes’ GDP growth estimate for 2026 is 3.0%, well above the Blue Chip consensus at 2.1%. We have a more constructive view on consumer spending, corporate capital expenditure (capex) investment and the housing market, and also anticipate less drag from a slimming trade deficit. We are expecting full-year earnings for the S&P of $320 in 2026 and $355 in 2027. Our target price for 2026 remains at 7,800, about 14% higher than last year, and 8,600 in 2027. But given the potential for increased financial market volatility this year – due to the Fed’s leadership transition and the midterm elections — we are cautioning investors to be vigilant and opportunistic, and encouraging them to buy any dips.
More to come next month We will return with January Barometer, Part II, in early February, after the S&P has generated investment returns for the entire month of January, to see what potential full-year market implications we can draw, and to identify what the top-performing industry sectors may be for the full year.
Read more about our views and positioning at Capital Markets.