Welcome to the October edition of Blackrock student of the market. Today we'll step back from the daily headlines and examine several historical market patterns that can help put the current environment in perspective. We'll begin with equities looking at the market's strong start to a midterm election year.
The relationship between consumer sentiment and subsequent returns, the current rate and recession backdrop and what volatility has historically look like during midterm years. We'll then turn to investor behavior, including record flows into sector funds and a potential year end tax issue for investors holding large, actively managed equity mutual funds.
Finally, we'll close with fixed income. Specifically, we'll look at why today's higher real yields and higher starting interest rates may create a more constructive long term backdrop for bonds. As always, the purpose is not to forecast the market with certainty. It's to use history to give us a more informed framework for evaluating risks, opportunities and portfolio decisions.
Let's begin with the strength we've already seen in stocks. After a sluggish first quarter, stocks rebounded strongly in the second quarter and held those gains through the third through September 30th. U.S. stocks were up 12.75% for the first three quarters of 2026. That ranks as the fifth best first nine month return among midterm election year, shown here.
The table on the left puts the result in historical context. It ranks the 15 strongest first three quarter performances in midterm election years, going back to 1926. The important point is not simply that 2026 has been strong. It is that strong momentum through the first quarter. This historically tended to continue, as the chart on the right shows the average one year return following the 15 strongest first three quarter performances was 23.33%.
There was meaningful variation around the average, including one slightly negative result. So this is not a guarantee of what comes next, but it does challenge the idea that a strong market must automatically be due for a reversal. That is an important behavioral point for investors. After a double digit advance, it can be prudent to wait for a better entry point.
History suggests strength by itself has not necessarily been a reason to reduce long term equity exposure. The practical takeaway is to avoid making an all or nothing decision simply because the market has already risen. Rebalancing may still be appropriate, but it should be driven by portfolio objectives and risk tolerance, not by the assumption that positive momentum must immediately end.
What makes that resiliency particularly notable is how poorly many consumers feel about the environment. This slide highlights one of the biggest disconnects we see in the current environment. Consumer sentiment is exceptionally weak, but historically we sentiment has not necessarily meant weak future stock returns.
The chart on the left tracks consumer sentiment back to 1978. The September 2026 reading was 48.1 below several previous low points highlighted on the chart. The slide attributes the weakness to affordability concerns war an unusually wide political divide. The party data illustrate that divide with sentiment at 77.2 among Republicans and 35.6 among Democrats.
That matters because survey responses may reflect more than underlying economic activity. They can also capture political affiliation, frustration with prices, and broader uncertainty. In other words, how consumers feel and how markets subsequently perform are related imperfectly. The chart on the right reinforces that point, following the historical sentiment lows highlighted here.
One year stock returns were positive in each instance, ranging from 18% to 33.5. More broadly, the slide shows an average one year return of 18.66% when sentiment was below 60, compared to 3.26 when sentiment was above 105. The lesson is that not is not that bad sentiment causes stocks to rise. It's that extremely pessimistic expectations may already reflect a significant amount of concern.
By contrast, very high confidence can coincide with elevated expectations and less room for positive surprise for client conversation. This provides a meaningful distinction and investor getting knowledge that affordability and geopolitical concerns are real, without concluding that those concerns automatically require abandoning a long term investment plan to understand whether that historical resilience can continue. We also need to consider the interaction between monetary policy and the economy. This slide examines forward returns across six different combinations of Federal Reserve policy and recession outcomes. The key message is that the direction of rates alone has not determined stock market performance.
The presence and or absence of a recession has been the more important dividing line. Focus first on the top right section, which represents the framework highlighted on the slide. The Federal Reserve raising rates with no recession within the next 12 months. Historically, that environment has produced an average one year return of 14.41% for U.S. stocks and 4.09% for bonds.
Now compare that with the bottom right section. When the Federal Reserve was raising rates and a recession occurred within 12 months. Stock averaged a -7.09%, while bonds averaged 12.97%. The same broad relationship appears in the other policy categories without a recession. Stocks recorded positive average for returns whether the fed was cutting, pausing or raising rates with the recession.
Average stock returns were negative across all three categories where bonds were positive, so the portfolio questions should not be limited to what is? What will the fed do next? A more consequential question is will. Economic growth remain durable enough to avoid a recession? This slide is slide's current framing is rising rates without an expected recession if that assumption holds.
History has generally been constructive for equities and closer to average for bonds. But the bottom half of the slide also makes the risk clearer if the economic outcome changes, leadership between stocks and bonds can change materially as well. This that supports maintaining diversification rather than building the entire portfolio around one monetary policy forecast.
Policy uncertainty and elections can still create anxiety. So let's separate the perception of election volatility from the historic record.
This slide measures volatility in a very tangible way. The number of trading days during a midterm election year when the stock market moved at least 2%, either up or down through September 30th, 2026.
We've experienced four such days. Those moves occurred on January 20th, March 31st, April 8th, and June 5th. That is relatively subdued compared to compared with periods such as 1932, 2002, 2008 or 2022, when the market experienced substantially more large daily moves. The right hand chart divides midterm election years into two groups.
Years with more than ten daily moves of at least 2% had an average stock return of -1.24%. Years with ten or fewer had an average return of 19.37. That doesn't mean low volatility guarantees a strong full year return. It does show that election years have not automatically been volatile simply because they contain an election.
The most volatile midterm years generally coincided with a broader market downturn, or in some cases, a powerful rally. The investor takeaway is that politics may dominate the news cycle, but market volatility usually requires a larger catalyst. Elections can influence taxes, regulation, trade policy and sector leadership, but they are only one variable among many.
If volatility does increase, the most productive response is generally to revisit portfolio risk, liquidity needs, and rebalancing discipline rather than react to an isolated 2% trading day. At this point in the year, the historical volatility measure shown here remains comparatively contained, even with relative contained volatility and investors that have not been passive.
They have been making increasingly large sector level allocations. Investors are using sector funds more heavily than at any point in the. History on this slide. Through August 31st, sector mutual funds and ETFs that attracted approximately 110,000,000,000 in 2026. That exceeds the prior high of $95 billion in 2020, and is almost twice the $59 billion recorded in 1999.
Technologies have been the dominant destination technology sector. Funds received 69,000,000,000 in 2026 through the period shown, compared to 21,000,000,000 in 25 and 22.3 billion in 2024. Industrials were second 19.3 billion, followed by natural resources and infrastructure. The slide connects the technology flows to the AI driven rally and the industrial flows to the defense spending and geopolitical concerns.
The broader point is that investors are increasingly using sector vehicles to express specific thematic and tactical views. There are two ways to interpret that. On one hand, sector funds can provide can provide precise exposure to a long term theme. On the other, the magnitude and concentration of current flows suggests that a significant amount of investor enthusiasm is moving towards areas that have already received substantial attention.
That makes portfolio context essential. Adding a technology fund to a portfolio that already has significant technology exposure through broad U.S. equity holdings may create more concentration than investor realizes. The same principle applies to industrials, energy, and natural resources.
The practical question is not simply do I believe in this theme, it is how much of this theme do I already own and what will I? What will the additions do to the total Portfolio sector funds can be very useful tools, but they should be sized within a deliberate allocation rather than treated as a substitute for a diversified core.
Investor movement has another consequence, particularly inside traditional mutual funds. It can create taxable gain distributions for shareholders who remain. This slide highlights a timely issue for investors who hold actively managed equity, mutual funds and taxable accounts. The 25 largest active stock mutual funds have an average fund size of $109, an average turnover of 30% and an average net outflow of $5 billion during the preceding 12 months, 22 of the 25 funds were in outflows, while average potential cap gain exposure was 55%.
Those figures can create the three part setup shown on the right. First, strong stock market gains have created significant unrealized gains inside mutual funds. Second, when a fund experiences redemptions, a portfolio manager may need to sell securities to raise cash. If appreciated positions are sold, the fund can realize capital gains.
Third, the tax burden is distributed across the share owners who remain in the fund. As the fund shrinks, those realized gains may be spread across a smaller asset base, potentially amplifying the tax impact impact for remaining investors. This is particularly important because an investor can receive a taxable distribution, even if the investor did not personally sell the fund.
An investor who purchases shortly before distribution may also receive taxable income associated with gains accumulated before that investor entered the fund. The planning opportunities to identify the exposure before the distribution occurs, whether rather than discovering it after the taxable event has already taken place.
Let's now shift to fixed income, where the reset in yields is creating different starting point for investors. Real yield is the return offered by a bond after adjusting for inflation. It is an important measure because it provides a better sense of the purchasing return available to the investor. As of September of 2026, the real yield and the ten year Treasury inflation protected security was 2.91%, according to the slide, that was the highest level since 2008, and close to the 3.14% level reached in October of 2008.
The chart on the right shows why this may matter. Since 2003, when yields were 2% or higher. Bonds produced an average return of 6.43% over the following 12 months, when real yields were between 0 and 2%. The average return was 4.02 when real yields were below zero. The average subsequent return was -2.55%.
There are two potential benefits to a higher starting yield. First, investors receive more income. Second, the additional income can provide a larger cushion against potential potential price declines if market rates move higher. This is a significant change from the environment in which inflation adjusted yields were near zero or negative.
In that environment, investors accepted a limited income and had relatively little protection against higher rates. Higher yields do not eliminate interest rate or credit risk, and short term bond prices can still fluctuate, but the starting point is materially different. Investors are now being compensated for more meaningfully for holding high quality fixed income for portfolios that moved heavily into cash or short duration instruments.
This may be an appropriate moment to reassess whether remaining extremely short still provides the best balance for income, reinvestment, risk and long term portfolio diversification. The improvement is not limited to the last the next 12 months. Starting rates also historically carried important information about long term bond returns.
This final slide provides a long term perspective on fixed income. The yellow bars show average annual ten year returns for bonds by decade, while the orange line tracks starting interest rates over time, there's been a visible relationship between the yield available at the beginning of the period and the returns by the return bonds subsequently generated.
The weakest decade shown is the 2020s, with 0.37% annual ten year return through the date presented. The week result followed a period in which interest rates began at historically lows, and the reset sharply higher. The slide compares the that experience with the 1940s and 1950s, when bond returns were also relatively low as rates moved upward from depressed levels.
The difference is the current rate occurred much more rapidly. The adjustment was painful for existing bond holders, but it has improved starting point for new capital and maturing proceeds being reinvested as of September 30th. The starting interest rate measure was on. The slide was shown to be 5.29% for the ten year Treasury, compared with the long term average bond return of approximately 5%.
The key distinction is between backward looking and forward looking experience. The low bond returns investors see, and trailing performance figures reflect the consequences of being with unusually low yields and experiencing a sharp rate increase. They do not necessarily describe the opportunity available.
Today's higher starting yields no historical relationship guarantees future performance. However, the long term evidence supports a straightforward principle. Starting yield matters after one of the most difficult bond resets. In modern experience, the prospective role of fixed income in providing income diversification and potential total returns appears more constructive than it did when interest rates were near zero.
To bring everything together, there are three main messages from this month's student of the market. First, equity markets have remained resilient. Stocks recorded the fifth best three quarter performance among the midterm election year shown, and historically strong momentum was often followed by additional gains.
At the same time, exceptionally weak consumer sentiment reminds us that investors experience and market performance can diverge meaningfully. Second, implementation matters record setting sector flows show that investors are leaning aggressively into selected themes, particularly technology.
Meanwhile, embedded gains, turnovers and outflows may create capital gain distributions of some of the largest active equity mutual funds there. There are reasons to review concentration and tax exposure, not reasons to abandon a disciplined investment plan. Third, the bond opportunity has changed.
Higher real yields and higher starting interest rates provide more income and a potentially stronger foundation for future returns than investors had when rates were near historic lows. The common thread is to avoid making portfolio decisions based on a single headline election outcome or backward looking return.
Instead, focus on diversification tax where implementation appropriate risk, and whether the portfolio remains aligned with the investor's long term objectives.
Thank you, and we'll see you next month on BlackRock's student of the market update.
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