Calm before the storm?

BOTTOM LINE:

Equity investors enjoyed a solid January to start the new year, with the S&P 500 rising by more than 1.4% last month. Importantly, the rally continued to broaden from last year’s second half, as international, domestic large-cap value and small-cap stocks all posted powerful January gains. Not so with domestic large cap growth and technology stocks (like the Magnificent 7), as investors locked in profits and rotated their proceeds into these previously laggard categories.

But this good start to 2026 may be the proverbial calm before the storm for investors, due to the extraordinary confluence of two potentially market-moving events that have occurred in the same year only six times over the past 92 years. This year will be the seventh. As a result, we’re bracing for a choppier and possibly more volatile year than normal over the next few quarters, before stocks find their sea legs and rally to a new record high into year end. So, be vigilant and opportunistic, and buy the expected dips this year.

Markets always test a new Fed chair Jerome Powell’s term as the Federal Reserve’s Chair will expire on May 15. President Trump recently nominated Kevin Warsh to replace him. Previously, Warsh had been appointed by President George W. Bush to the Fed’s Board of Governors, where he served from 2006 to 2011. The Senate Banking subcommittee will vet Warsh in the coming months, with the full Senate likely voting to confirm his candidacy in April.

But Congress and investors are very concerned about the status of Fed independence under Chair-designate Warsh. Since 1933, each of the 11 new Fed chairs—from Eugene Black to Jerome Powell—was greeted by the equity markets in similar fashion. Each chair enjoyed a brief honeymoon for a few months; stocks then corrected by about 10% over the next quarter or two, as investors became concerned about the new Fed Chair’s monetary policy chops; and finally, once investors became comfortable with the new Chair, stocks rebounded to new record highs into year end.

Downside risk rises during midterm election years Equity indices typically move up and to the right over time, as stock prices reflect rising economic growth and corporate profits. But if we organize historical stock-price performance into the four years of the Presidential Election Cycle, and then group that performance into quarters, we notice that 14 of the 16 quarters are usually positive, but the two middle quarters of the midterm election year are routinely negative.

The reason for that, we believe, is the political pendulum which usually swings away from the White House in the midterm elections. At present, Republicans hold an extremely narrow four-seat lead in the House of Representatives, with three open seats. But if we look at every midterm election from FDR in 1934 through Joe Biden in 2022, the party out of executive power has regained an average of 27 seats in 20 of those 23 elections. In recent decades, only Bill Clinton in 1998 and George W. Bush in 2002 managed to see their party gain seats.  

This political prospect is unnerving for investors, who just voted the current leadership team in Washington, DC into power some 18 months earlier to orchestrate a particular set of fiscal policies. As a result, stocks typically decline by 5-10%, reflecting fiscal policy uncertainty. But as markets successfully discount the midterms by the fourth quarter, stocks tend to bottom and rally to new record highs through year end and into the next two years.  

Double trouble? The extraordinary confluence of these two events—a leadership transition at the Fed occurring in a midterm election year—has occurred in the same year only six times over the past 92 years: 1934, 1970, 1978, 2006, 2014, and 2018. Put together, the S&P 500 experienced an average drawdown of 17% in each of these years (ranging from a 7% decline to 29%) before bottoming early in the fourth quarter and surging to a new record high before year end.   

“January Barometer” positive in 2026 According to the “January Barometer,” one of the stock market’s most popular and widely followed rules of thumb, as the month of January goes, so goes the full year. Since 1950, Jeffrey and Yale Hirsch at the Stock Trader’s Almanac report that the performance of the S&P 500 in the month of January—positive or negative—is an accurate directional signal for the full-year performance of the stock market 74% of the time (56 out of 76 observations). But when January is a positive month—as it was this year—the odds of a positive full year rise to 89% (41 out of 46 instances).    

Good start to the year augurs well for the full year Since 1950, there have been 42 instances in which the S&P 500 rallied by 1.0% or more in January, and the index finished the full year in positive territory 93% of the time (39 out of 42 observations), with an average full-year return of 18.2%.

If we review a narrower range, in which the S&P 500 rose by 0.2% to 2.7% during January—compared with this year’s 1.4% rally—stocks rose more than 94% of the time (17 out of 18 observations), with an average full-year return of 14%.  

Fundamentals still matter That’s right in line with our fundamental forecast for the S&P 500 this year, on the heels of three powerful years in a row: 24.2% on a price-only basis in 2023 (26.3% on a total-return basis); 23.3% in 2024 (25.0% total return); and 16.4% in 2025 (17.9% total return). We’re expecting a 14% price-only rally to 7,800 by year-end 2026.  

What are the best sectors to own in 2026? The “January Barometer Portfolio” indicator also holds that the best- and worst-performing S&P 500 sectors in January tend to follow that performance trend the rest of the year.  Here are the mixed results from the S&P 500’s 11 sectors, sorted by their total-return performance from December 31, 2025, through January 31, 2026. 

• Energy, 14.4%
• Materials, 8.7%
• Consumer staples, 7.7%
• Industrials, 6.7%
• Communication services, 5.8%
• REITs, 2.9%
• Consumer discretionary, 1.7%
• Utilities, 1.4%
• S&P 500, 1.4%
• Health care, 0.0%
• Information technology, -1.7%
• Financials, -2.5%

Sector results for January are illuminating, suggesting a rotation away from large-cap growth and technology, which have performed very well over the past three years, and toward the laggards, which include international, domestic small caps and domestic value: 

• MSCI EM, 8.9%
• Russell 2000, 5.4%
• MSCI EAFE, 5.2%
• Russell 1000 Value, 4.5%
• S&P 500, 1.4%
• Russell 1000 Growth, -1.5%