US Midterm Elections a Catalyst for Stocks
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Elliott Gue PFNewsletter .com |
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US midterm elections are clearly weighing on investor sentiment these days. At the San Francisco MoneyShow, attendees repeatedly for my take on the likely result of upcoming elections and whether midterms would be a catalyst for stocks this year.
In London this week, a friend reminded me that political discussions are much like Marmite, a yeast breakfast spread that’s popular in the UK and Australia. If you like Marmite, you tend to love it; if you don’t care for the spread, it’s likely that you absolutely detest it. Political commentary is similarly polarizing, a sort of third rail for newsletter editors. I will wade carefully in this territory and keep my commentary as neutral and unbiased as possible.
US midterm election years have a reputation for producing market weakness and volatility--2010 is shaping up to be no exception.
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There’s a fundamental reason for the market’s aversion to the election cycle: uncertainty. Markets abhor a lack of visibility about the direction of government policy. Not surprisingly, the market is usually weakest in the months leading up to an election and stronger once the results are known.
This year the political picture is even cloudier than usual. For one, persistently high unemployment and conflicting signals from key economic indicators do little to instill confidence in the recovery. This weakness has prompted many commentators to fan the flames and argue that a double-dip recession is inevitable, adding to the prevailing negativity. But as I noted in Still No Double-Dip Recession, history and economic data suggest the US will skirt a double dip, though the economic recovery will prove to be subpar.
The Obama administration’s policies have introduced their fair share of uncertainty. Whether you agree or disagree with the government’s actions, over the past 18 months the administration has pushed through financial and health care reform as well as a massive economic stimulus package. Other legislation is in the works that would affect the energy sector, for-profit education companies and, of course, personal taxes.
Major reforms aimed at important segments of the economy involve boatloads uncertainty, regardless of whether these efforts represent “good” or “bad” public policy.
Executives at the major US drug and health care companies repeated this concern throughout their second-quarter conference calls; management teams were loathe, or unable, to provide much clarity on how much the bill will cost and the implications for long-term growth.
Financials are in a similar boat. Although some of the scariest provisions were removed from the final bill, the S&P 500 Financial Index has underperformed the broader market dramatically the legislation passed.
The outcome of this year’s midterm election won’t have much of an immediate impact on the health care or financial reform bills. But the election will influence major new policy initiatives.
Taxes are one issue that’s front and center. As most investors are keenly aware, the so-called Bush tax cuts expire at the end of the year. This would mean increases to income tax rates as well as taxes paid on dividends; if Congress does nothing, taxes will revert to prior levels.
Neither the Republicans nor the Democrats want this to happen; raising taxes amid high unemployment and a shaky economic recovery isn’t likely to be a popular move. And if the economy were to slip into recession over the next two years, you can bet that the party in power would bear much of the blame.
Republicans would like to make the lower tax rates permanent, including the special 15 percent qualified rate on dividends. The administration and many Democrats have proposed keeping rates at the lower levels for those making under a certain amount and raising taxes on wealthier Americans.
Neither party is likely to change their position much ahead of the midterm election. If President Obama and the Democrats were to cave in to Republican demands for an extension, they would appear weak ahead of the polls. And Republicans are getting considerable political mileage out of the idea that the administration plans to raise US taxes; I see no reason for that rhetoric to change until after the November elections.
Uncertainties about future tax policy continue to weigh on the markets. The frequency with which readers ask me about the elections and tax policy suggests that these topics are high on investors’ minds.
When it comes to predicting election winners, I steer clear of the talking heads on political news programs and examine data from Intrade, a firm that allows investors to bet real money on the outcome of various races. In recent elections Intrade prices have proved to be surprisingly good predictors of actual results. Intrade prices suggest a more than 75 percent chance that Republicans will win enough seats in the US House of Representatives to wrest control from the Democrats. The odds of a Republican win have been rising steadily over the past four months, a sign that momentum is in the GOP’s favour.
At the same time, Intrade prices in a roughly 67 percent chance that the Democrats will retain control of the US Senate after November. However, the market projects that Republicans will pick up a significant number of seats; on average, Intrade prices suggest the GOP will control about 47 seats in the Senate.
If this outcome holds, the elections could be a positive catalyst going into 2011. With a majority in the House, the Democrats would no longer control the legislative agenda. And although the Democrats would retain control of the Senate, they’d be well shy of the 60-seat supermajority needed to break a Republican filibuster. In this scenario, it will be tough for the Democrats to pass any laws without significant Republican support.
Such gridlock has historically been a better outcome for stocks than when a single party has clear control.
A US carbon dioxide cap-and-trade bill would be one likely casualty. This bill is already dead for 2010 because Democrats lack enough internal support to vote such a policy into law. With the Republicans in control, a cap-and-trade scheme is likely off the table until at least 2012.
A more likely scenario is that Congress will pass an energy bill that subsidizes alternative energy as well as nuclear power and natural gas--two sources favored by Republicans. Such an outcome would be another major negative for stocks levered to alternative energy. Investors had expected climate-change legislation to provide a major catalyst for the group, and many had already expected an extension of existing subsidies.
But the 800-pound gorilla in the room is tax policy. Under a true gridlock scenario, US taxes will rise at the end of the year. That’s because Congress doesn’t have to take any action to raise taxes; rates will simply revert to their pre-Bush levels at the end of the year.
I suspect that Congress will not allow the tax cuts to expire completely. Expect some sort of compromise legislation to emerge after the election. Such an agreement could include a temporary extension of the tax cuts to all Americans, phasing out tax cuts over a period of many years for wealthier Americans, changing the definition of “wealthier” Americans or balancing tax hikes in some areas with cuts to corporate income taxes or taxes on dividends and capital gains. Raising taxes in a weak economy is just too unpopular. Broadly speaking, expect uncertainty surrounding the midterm election and tax policy to dissipate over the next four to six months--a potential upside catalyst for stocks. Such an outcome would support my projection that the US stock market will rally significantly into year-end.
Energy Talk
In a market addled by near-term uncertainty, investors should take advantage of volatility to buy stocks leveraged to key structural trends. Favorable supply-and-demand dynamics make energy stocks a must-own for growth investors.
For more details on the best way to play the long-term bull market in energy as well as shorter-term bets, register to attend the live webinar I'm hosting on Sept. 22 at 1:00 pm EST. Attendees will have ample opportunity to ask me any questions about specific stocks and bigger-picture themes. Click here to sign up today.
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Elliott H. Gue is editor of Wall Street Winners the premier monthly growth newsletter designed to manage investor’s portfolio risk. Mr. Gue examines the market sector by sector to find the industries with big tailwinds and avoid investing pitfalls. Mr. Gue uses both top-down and bottom-up approaches to search the global stock and currency markets for strong intermediate-term trends, picking investment vehicles accordingly.
Mr. Gue is also editor of Trading Floor Pro and a research analyst for Personal Finance, where he specializes in global equity and debt markets and also has broad interests in technology and sector investing.
He has worked and lived in Europe for five years, where he completed a Master’s degree in Finance from the University of London, the highest-rated program in that field in the U.K. He also received his Bachelor’s of Science in Economics and Management degree from the University of London, graduating among the top 3 percent of his class. Mr. Gue was the first American student to ever complete a full degree at that business school.
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