Competing Signals: Markets Ahead of the Midterms

MIKE TOWSEND: How should investors think about history? Every investor knows that past performance is no guarantee of future results, yet historical performance is still a very powerful influence on investors. But is it still important? Markets have historically been volatile, but ultimately almost flat in the three months leading up to an important election. In fact, during the last 13 midterm election years, the S&P 500^® has averaged less than a 2% gain from August 1 through Election Day, according to historical return data provided by Yahoo Finance. But once the election is over, markets have reacted positively, with the S&P 500 averaging more than a 12% gain in the six months immediately following those 13 midterm elections. 

So will 2026 follow the historic pattern, or will this year's market, which has seen double-digit returns since the beginning of the second quarter, continue to power upwards right through the election and beyond? 

While there's no way to truly discern what the market will do, there are usually signposts to read along the way to get some sense of direction. But this year several different signs seem to be competing for the role of market driver, and that makes them particularly difficult to read. Strong earnings have been the fuel to the market rally, and there's little indication of that slowing down. But elevated inflation, turmoil in the bond market, and the increasing likelihood of a Fed interest rate hike have investors on edge. 

So as we get closer to the election, which signs should investors be focused on? Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to. 

Coming up, my colleague Joe Mazzola, head trading and derivative strategist at Charles Schwab, joins me for a conversation on the current state of the markets and about whether historical performance is a relevant metric today. We'll talk earnings, what the bond market turmoil means for the equities markets, what diversification means in an environment in which nearly two-thirds of the S&P 500's earnings growth has come from just 10 companies, and much more. I think you'll find this conversation worth your time. But before we get to that, here are three things I'm watching in Washington right now. 

First, all eyes are on next week's monetary policy decision by the Federal Reserve. The Fed will convene for two days of meetings on September 15 and 16. And there's widespread speculation that the Fed may hike its baseline interest rate for the first time since 2023. Fed futures markets were forecasting about a 60% chance of a hike on September 8, just a week out from the meeting. At the beginning of the year, the question was how many rate cuts there would be this year, and there was a 0% expectation that there would be a rate hike in 2026. But the war in Iran, sticky inflation, new rounds of tariffs, an anxious bond market, and other factors have created a completely different environment. 

In a late August speech at the Fed's annual symposium in Jackson Hole, Wyoming, Fed Chair Kevin Warsh clarified that the committee remains focused on getting inflation back to its long-standing 2% target. The inflation rate has not been that low in more than five years, and it's been hovering between 3 and 4% throughout 2026. Last week's jobs report, which saw robust hiring in August that surpassed expectations and also saw numbers from June and July revised upwards, only added to the sense that the Fed will be laser focused on getting inflation under control. And that has many investors leaning toward a rate hike sooner rather than later.

Second, the big news from Capitol Hill is that there won't be any last-minute drama at the end of this month about a government shutdown. Last week, the House, in a rare pre-Labor Day session, overwhelmingly approved what is known as a continuing resolution, a measure that will fund government operations from October 1 through December 11. With the Senate having passed the measure in early August, the president signed it into law, and that ensures there will be no government shutdown five weeks before the election. 

The bipartisan vote of 370 to 48 was a reflection of the fact that neither party sees any political advantage in shutting down the government so close to the election. So, in typical fashion, Congress did what it does best, punted a problem down the road a few months. Of course, the underlying issue hasn't gone away. Congress has not passed a single one of the 12 appropriations bills that they're supposed to pass each year to fund every government agency and program.

And they're highly unlikely to pass many, if any at all, between now and December 11, the next deadline. When Congress returns after the election for what's known as a lame-duck session, they'll have to deal with that new deadline, which will probably mean another temporary solution that funds the government until early in 2027.

And that means that the budget will become a problem for the next Congress to solve when it convenes in January. I've said before that historically markets have not really cared about government shutdowns. Last fall saw the longest government shutdown in history at 43 days. Yet the S&P 500 went up more than 2% during the shutdown. 

But this repeated cycle of temporary funding measures has become an annual ritual that underscores just how dysfunctional Congress has become. Congress is increasingly abandoning the appropriations process entirely, and that means there is less and less scrutiny of how taxpayer money is being spent. Without the normal appropriations process spending decisions made, in some cases years ago, are just being extended, without much focus on whether they merit continued funding, or conversely, whether they merit more funding than the current levels. 

And that relates to my third notable development of recent weeks. The United States hit a rather ignominious milestone last month when our national debt surpassed $40 trillion on August 18, according to the Treasury Department. The gigantic federal debt means that interest on the debt is projected to top a trillion dollars this year, making it the second largest expenditure of the federal government after Social Security. Earlier this year, the U.S. publicly held debt exceeded GDP, and it's on track to break the debt-to-GDP ratio record set in the years immediately after World War II. 

The debt is also rapidly approaching the debt limit, the maximum amount of borrowing set by Congress. Lawmakers approved a debt ceiling of $41.1 trillion last year as part of the so-called One Big Beautiful Bill. That means a debt limit fight is looming for the new Congress in mid-2027. And raising the debt limit has become one of the most difficult political battles on Capitol Hill in recent years, and it will be more complicated if November's midterm elections result in a split Congress. But despite this avalanche of worrisome data, the will in Congress to make the difficult decisions to start chipping away at the debt or even get the annual federal budget deficit under control seems to be at an all-time low. 

The rising cost of servicing the debt and the apparent lack of interest in addressing it is a contributing factor in the recent turmoil in the bond market. Yields, particularly on longer-term bonds, have risen to the highest levels in years here in the United States. And around the globe, elevated bond yields in countries like France, Germany, Japan, and the United Kingdom are reflective of those countries' debt issues as well. At some point in the near future, Congress is going to have to get serious about addressing the fiscal problems. That's a very hard discussion at any time, but especially two months before an election.

But the bond market may be signaling that Congress won't be able to put that discussion off forever.

On today's deeper dive, I want to take a look at what's going on in the market right now and whether history can still be a helpful guide in understanding it. Frankly, there's a lot going on in the market, with the S&P 500 up double digits year to date on the strength of booming earnings for companies. But we have also seen turmoil in the bond market, the growing sense that a Fed interest rate hike may be coming soon, and a looming midterm election that tends to increase volatility.

So to help me sort through it all, I'm really pleased to welcome back to the podcast Joe Mazzola, Schwab's head trading and derivative strategist. Joe is a former portfolio manager who is fantastic at helping traders at all levels of experience understand what's going on in the markets and how to invest in different market environments. Joe, thanks so much for joining me today.

JOE MAZZOLA: Hey, Mike, thanks for having me.

MIKE: Joe, let's start the conversation talking about history from an investing perspective. Now, we all know that past performance is no guarantee of future results. But for investors, historical performance remains a powerful metric. There's an adage that history doesn't repeat itself, but it often rhymes. But time and again in 2026, that just has not been the case. The markets have absolutely gone their own way. And that just might be a good thing here in the run-up to the midterms.

Typically, the months leading up to an election have not been strong ones for the market. And that's particularly true in midterm election years. Since 1974, the average S&P 500 return from August 1 to Election Day is about 1.7%. And that is skewed by a single outlier year, 1982, when the market surged more than 26% during that window. Exclude that and the S&P 500 will be averaging a loss in the run-up to an election in every midterm year since 1974. Volatility tends to be up in the months leading up to an election as well. But not this year. Yes, the market has been volatile, but August has seen a positive return for the S&P 500 of nearly 3%. And we are up about 12% for the year as we head into September. So, Joe, help us out. What's going on here?

JOE: Mike, I think the biggest driver's been the strength of the earnings backdrop. Companies, they're not just beating estimates, they're doing it with real profit, revenue, and margin growth. If you take the most recent earnings cycle as an example, expectations were for roughly 25% year-over-year growth in the S&P 500 earnings. I thought that was a high bar. And look, we're tracking closer to 50%. That's effectively double what analysts had expected. And it's not just a cost-cutting story, Mike.

Revenues are up 15% year over year, and profit margins rose roughly 14% in the second quarter. In fact, margins, they're at their highest level since at least 2009. And, Mike, you usually don't see those types of profit, revenue, and margin growth moving together at these kind of rates unless the economy is coming out of a recession, like we saw in 2009. That makes this an unusual environment, and it helps explain why the market has been able to maybe look past some of the typical midterm election seasonal weakness. So I'd say the risk from here is that maybe expectations have moved a little too high. Maybe the bar for the back half of this year and into 2027 is now meaningfully tougher to clear. And the markets may need to continue that earnings strength, not just stability, to kind of keep this momentum going.

MIKE: Joe, on this show, we don't typically get into the performance of individual companies, but given the attention on NVIDIA at the end of August and the blowout numbers it announced, I want to ask you about the company and the context of your comment about expectations getting tougher to clear. I mean, is it realistic to think NVIDIA and maybe some of the other high-flying companies in the AI and AI-adjacent space, is it realistic to think they can keep beating expectations so dramatically?

Or is the risk rising to a level that's concerning? It's a particularly important question because it feels like just about every investor owns NVIDIA and some of the other big names these days, either directly or through exchange-traded funds or mutual funds.

JOE: Absolutely. I think NVIDIA is a perfect example, Mike, of the earnings backdrop we just discussed. The company just reported second-quarter earnings per share of $2.22, gross margins of 75%, and revenue, Mike, of 96.2 billion. That's a decent GDP for many countries. So I think it's fair to say that this 16% rally in the share price over the past month, it's been supported by real revenue and profit growth. And kind of reinforced by those 75% margins. 

I think the challenge that is the stronger these results get, it becomes harder to keep surprising investors. At some point, big beats, raises, they stop feeling like upside surprises, Mike, and they start becoming the expected baseline. So the question shifts from "Can they beat and raise?" to "Can they beat and raise enough?" Stocks like NVIDIA and much of its chip brethren, they're pricing in continued AI infrastructure spending, stronger pricing power, and aggressive customer demand. So if any of those pieces disappoint, even modestly, that can lead to an outsized reaction. And that matters for the broad market because of what you just spoke about, the exposure that's so widespread through indexes, ETFs, and even growth-oriented funds.

The AI story is still very real, but the expectations have caught up in a major way. So from here, I think it's important that investors need to be more selective. I think they need to understand their exposure. And I think they need to avoid assuming that past upside surprises can continue indefinitely.

MIKE: Yeah, I think it's a great point about expectations and whether these companies can keep exceeding them. 

I want to throw some other numbers at you. Using the same midterm election year since 1974 that I was referring to earlier, the S&P 500 is up an average of 5.7% three months after the election, and up more than 12% six months after the election. In fact, the market has been up six months after a midterm election every single time since 1974. So that's 13 midterms in a row. And that's regardless of the actual outcome of the election. Essentially, markets don't seem to really care about the result of the election. They just care that the election is over. So, first of all, do you anticipate that same sort of bounce? And secondly, what are the catalysts you're seeing that could drive a positive move this time around?

JOE: Perhaps. But I think the key question is how much of that typical post-election bounce has already been pulled forward? For me, the bigger concern is less about the election outcome itself and more about what forward returns look like after such a strong three-year run in the market. Valuation pressures, they've eased, right, because earnings growth has outpaced the multiple expansion, but the quality of that growth matters.

And lately it's been concentrated in a relatively narrow group of companies. You know, our colleague Liz Ann Sonders, she and I were discussing this recently, and she pointed out to me that 32% of the S&P 500 earnings growth from 2025 to 2026 came from just two companies, NVIDIA and Micron. And if you broaden that to the top 10 contributors, you're going to add Alphabet, Microsoft, Meta, Broadcom, Amazon, Apple, Chevron, and Exxon. Now, those companies, they accounted for roughly 65% (or two-thirds) of the index's entire earnings growth from 2025 to 2026. And that concentration does not mean, Mike, that the rally necessarily has to fail, but it does mean that the market either needs that same leadership group to keep doing the heavy lifting, or maybe it needs broader participation from new leaders.

That can absolutely happen, but the concentration of earnings growth, to me, that's the risk that investors should keep in mind.

MIKE: Yeah, expand a bit on the idea of broader participation from new leaders. As a trader, where are you seeing those possibilities? Is it more traditional blue chips that maybe haven't been in the headlines recently? Is it small-cap stocks? After all, the Russell 2000 has outperformed both the S&P 500 and the NASDAQ this year. Is it AI companies that maybe aren't the familiar names? Is it international? I mean, where should an investor who wants to diversify be looking?

JOE: Let me dispel a common myth, Mike. Diversification is not just owning more stocks. It's owning different sources of returns. And if earnings continue to support a broader market expansion, then I'd assume that the traditional blue chips that you talked about and the cyclical areas that have kind of been out of the spotlight, whether those are financials, industrials, healthcare, energy, look, they could benefit. But be mindful that we've seen multiple market sector rotations in these past few months. So trying to predict sector outperformance is often difficult. Small caps, another area you brought up, I think that's another place to watch. As you noted, the Russell 2000 outperformed both the S&P 500 and the Nasdaq this year, and not just this year, but the last two years. And that suggests investors, they're looking beyond mega-cap growth. The caveat is that small caps are often very rate sensitive. So higher yields or renewed Fed-hike expectations, that could create some pressure on that group. But even within AI itself, if you want to dig a little bit deeper, I'd look beyond the most familiar names. I think at this point in the cycle, there may be opportunities in things like power, cooling, networking, data center infrastructure, software, and services. And these are areas, Mike, that can benefit if AI cap spending remains strong, but they're not always the headline stocks.

And I'll leave you with international markets because I think they're also worth considering for investors trying to reduce maybe some U.S. tech concentration. If you look at these broader international indexes, they generally have more exposure to financials, industrials, healthcare, and less exposure to IT than the S&P 500. So the key is not to choose diversification for the sake of diversification, right? Investors should match it to their risk tolerance, their income needs, and their time horizon. But for anybody heavily exposed to the same handful of mega-cap growth names, I think it's a good time to ask where that next layer of earnings leadership could emerge.

MIKE: Well, Joe, we've been in a long period where the markets just don't seem to follow the historical business cycle. And people are fond of saying, "Well, it's different this time." We both hear that all the time. Right now we have kind of an unusual set of circumstances.

The Fed could be looking at raising rates. Inflation has been sticky, but not out of control. Economic growth has been OK, but not great. Yet the second quarter saw that tremendous earnings growth you were talking about almost across the board. 85% of the S&P 500 beat earnings expectations, and that's higher than usual. And the S&P 500 has hit a record high 27 times this year. Now I've been hearing from a lot of investors, and I bet you've been hearing this a lot too, that they feel like there's kind of a disconnect between how they feel about the underlying economic data, frankly how they feel about the world in general, and how the market is performing. So I guess the question is, is it different this time? Is any of the historical information we've been talking about still relevant?

JOE:  I don't think history has stopped mattering. But I think what feels different is the starting point. We came out of a pandemic, and investors had to work through a series of unusual distortions, whether that's a demand shock, a multi-decade spike in goods and services inflation, and even the fastest rate hike cycle in decades. So while most of those pressures have eased, even if they haven't disappeared entirely, it's the market's response that's not as disconnected from history as it may feel, because stocks tend to look forward, not backwards.

So if earnings are beating expectations and inflation is no longer accelerating, investors, they see the Fed as moving at a more measured pace, and then the market can continue to move higher even when the economic backdrop feels mixed. And new highs, often they do feel unsettling, but historically, they are a normal feature of bull markets, not an automatic sell signal. The bigger issue in my mind, Mike, is that the profit expectations have risen, and understandably so after such a strong earnings cycle. But that does mean that the bar is higher from here. And it does mean that the basic playbook is still intact, but the market is going to need continued earnings strength, manageable inflation, and a Fed that does not surprise investors in the wrong direction.

MIKE: I want to get to the Fed in just a second, but Joe, I know you mostly focus on equities, but it feels like recently bonds are driving the conversation. In mid-August, the 30-year yield hit its highest level in nearly two decades. The bond market appears to see rising risks, inflation, geopolitical conflicts, tariffs, companies spending tremendous amounts of capital on AI, exploding government debt. The list goes on. Global central banks are expected to tighten, some sooner and more aggressively than in the U.S., and that in itself can put pressure on U.S. rates. 

Now the Treasury Department is looking to normalize the yield on 30-year Treasuries through a buyback. That hasn't exactly worked out as Secretary Bessent hoped, and it may not. Yields are staying up because Treasuries have a lot of competition from corporate bonds, especially those in the AI arena. As the cost of borrowing rises, that directly impacts people's ability to buy things— cars, homes—and that of course puts corresponding pressure on auto companies and home builders. Big picture, higher borrowing costs hurt companies in their bottom lines, and that means their stock prices can get dinged. So how concerned are you about what's going on in the bond market and the impact it may have on equities?

JOE: Well, Mike, I'm going to preface this by stating that, as you mentioned, I am not a bond strategist, but an equity person. And so, with that being said, I do pay attention to what the bond market's telling us. And that's telling us that higher yields are basically a higher price tag on money. And so for Main Street, that means mortgages, car loans, credit cards, small-business financing, it's all getting more expensive. And for Wall Street, it matters because higher rates compete with stocks and make future earnings less valuable in today's dollars. But there's also raised borrowing costs for companies, and that can pressure their margin and earnings. I think the key distinction is why are yields rising? If rates are moving up because growth is solid and earnings are improving, I think equities can usually handle that. But if yields are rising because investors are worried about inflation, deficits, tariffs, or too much debt supply, Mike, that's a different story. And that can become a real headwind for valuations.

I think that's a long-winded way for me to say that I'm concerned, but I'm not alarmed yet. I think the bond market is something equity investors shouldn't ignore. And I also think that if earnings keep holding up, stocks can absorb some pressure from high yields. But if higher rates start hitting Main Street spending and corporate profits, at that point it becomes much harder for equities to keep shrugging it off.

MIKE: Are you seeing this start to play out in specific sectors yet, or is it across the spectrum?

JOE: I think right now there's no question that the cost of financing this massive AI build-out and broader corporate capital spending is rising. While this mainly affects the technology sector, you still can see these tangential effects with utilities, real estate, industrials, as they tend to be interest-sensitive sectors. I think specifically with tech, Mike, many of the companies that were once viewed as these cash flow kings, with the strong balance sheets, now they're taking on billions of dollars of debt through bond issuance.

And that's going to raise their weighted average cost of capital. It's going to raise their overall funding costs. And it kind of changes the risk profile that investors have to consider. I think we're also seeing a meaningful amount of convertible debt come to the market. Now, convertible debt gives the purchasers of that debt the right to convert those holdings into equity shares prior to expiration. It's almost like a call option, but I think with many AI and AI-adjacent companies, they're using these convertibles as another way to secure funding beyond the traditional debt market. Now, look, that can be attractive for investors if their growth story continues to play out. But it also introduces risks, as default risk in the corporate bond market and potential dilution or maybe saturation risk through the convertible market if these securities are converted to equity shares. So I don't think we're at a stress point yet. And I look at the credit spreads as a way to tell that. Now, credit spreads, they're the difference between the yields that investors demand on corporates versus Treasuries. They haven't blown out—they have moved higher, Mike, but still it's something to keep an eye on. And I think overall the bond market is sending an important signal. And it's that the financing costs keep rising. And that can eventually pressure margins, and capital spending plans, and equity valuations, especially in the parts of the market that are most dependent on the long-duration growth assumptions. 

MIKE: Well, speaking of signals, we got what I think was a pretty useful signal from Fed Chair Kevin Warsh at the end of August when he gave a speech at the Fed's annual symposium in Jackson Hole, Wyoming. Key take away from me was that he committed to the Fed's 2% inflation target. Now, we know about Kevin Warsh's disdain for forward guidance. And he quite directly said that he was committing to a discipline, but not a direction, for rates. Nonetheless, the market seems to be interpreting his remarks to say that a rate hike could be on the table as soon as next week's FOMC meeting. That's obviously not what anyone was thinking at the beginning of the year. So how is the equities market thinking about a Fed hike?

JOE: Look, the probabilities for a September rate hike jumped pretty high after Jackson Hole, and they continue to move up even higher. Right now we're around 65%. I think what's notable is how equities seem to have digested that shift. In some ways the market may be saying, "Look, now at least we know what to prepare for. So let's just get on with it." For equities, the issue is less about one hike, and it's more about why the Fed is hiking. If it's about sticky inflation and defending that 2% target, I think that can really pressure valuations, especially in the long-duration grow stock—the small caps, the real estates, utilities, and the highly levered companies. But if the market sees the hike as confirmation that growth and earnings are holding up, I think equities can absorb most of that. And that goes back to the earnings backdrop we discussed earlier. Strong profits, revenue growth, and margins, it kind of gives stocks a bit of a cushion. In my mind the market is trying to decide whether this is a growth-confirming hike or an inflation-fighting hike. The first is manageable, but the second is a little bit more concerning because it can mean higher discount rates and tighter financial conditions. And at that point, that's more pressure on earnings.

MIKE: Yeah, I love that thought of the growth-confirming hike versus the inflation-fighting hike. It's a really important distinction. 

Love this discussion as always, Joe. Let's end with what you're expecting for the next few months, maybe through the election and perhaps into early 2027. What are you telling traders? Are there moves investors could be making to protect what they have if there's some short-term volatility over the next couple of months? And what about investors who are anticipating that positive, post-election move for the markets, given the history of strong returns in the six months following a midterm election.

JOE:  You know what I hear, Mike? I hear a lot of people that are waiting for that other shoe to drop. They're waiting for the pullback. And I think for those investors that are concerned about that broad market pullback, right now the cost of hedging is still relatively low. So if you look at the VIX, which measures the implied volatility in the S&P 500, it's below 15. And the CBOE SKEW Index, that's a market-based measure of tail risk, it's currently around the 43rd percentile. So, in plain English, that's just a couple ways of saying that downside protection is relatively cheaper than it's been in roughly half the time over the past year. And I think this creates an opportunity for investors to think through risk management before volatility rises. I think that's the key rather than after. So, for example, for investors with concentrated positions that have appreciated significantly over the past few years, you may want to consider some strategies that help reduce some of that downside risk. To me, the key point is that investors don't have to make an all-or-nothing decision. If they're worried about short-term volatility but don't want to abandon their long-term positions, there's defined risk strategies that can help them stay invested with a clear path. We teach a lot of these approaches through our Schwab Coaching on our YouTube Trader Talk channel. And I know that the branch teams are having these strategy conversations with clients as well. So if clients are really that concerned about protecting gains or preparing for potential volatility around the election, I'd encourage them to use those resources and talk through what fits their own situation.

MIKE: Well that's a great place to wrap it up, Joe. Really appreciate your time. Thanks for joining me today. 

JOE: Thank you, Mike.

MIKE: That's Joe Mazzola, head trading and derivative strategist here at Charles Schwab. You can read Joe's commentary on schwab.com/learn and follow him on X @JoeMazzolaCS.

Well, that's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks when my colleague Collin Martin, Schwab's chief fixed income strategist, will join me to discuss the Fed's monetary policy decision, why the bond market has been in the headlines so much recently, and more. Take a moment now to follow the show in your listening app so you get an alert when that episode drops and you don't miss any future episodes.

And don't forget to leave us a rating or a review. Those really help new listeners discover the show. For important disclosures, see the show notes or schwab.com/WashingtonWise, where you can also find a transcript. I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.