On Tuesday Barack Obama was reelected president and during the next two days the Dow Jones Industrial Average lost 434 points, or 3.3%, which is the largest two-day decline in a year. What are the implications of the 2012 election for investors and are they as dire as this week’s sell-off seems to suggest? Is the impending “fiscal cliff” as serious as many commentators think? I want to reflect on these questions and offer some of our views at O’Brien Greene about the significance of the election and other political issues for investors in the market.
Congress & the President
For the past two years Democrats have controlled the White House and the Senate and the Republicans have controlled the House of Representatives. Last night’s election assures that this status quo will remain at least for the next two years until mid-term congressional elections in 2014: with most of the votes counted, Obama won the presidency with 50.3% of the popular vote, against Romney’s 48.1%; Republicans maintained their control of the House; Democrats increased their Senate majority by two.
From an investor’s perspective, perhaps what’s most noteworthy about the election results is what did not happen. First, Obama won the presidency clearly, but without anything like the electoral mandate he received in 2008. The clarity of Obama’s victory therefore avoided the destabilizing uncertainty that would have followed a deadlocked presidential race, such as the Bush vs. Gore Florida recount debacle in 2000. Many polls had indicated that a deadlock was a real possibility, but it is unquestionably good for financial markets that we avoided it.
Given the clarity of Obama’s victory, however, compared to his 2008 performance Obama’s defeat of Romney was narrower. In 2008 Obama received 365 electoral votes to John McCain’s 173, whereas he beat Romney 303 to 206. Obama’s weaker showing in 2012 means that he will have limited political momentum to turn toward any big policy goals in his second term. It is worth remembering that all of Obama’s big legislative policy accomplishments from his first term—Obamacare, the stimulus package, Dodd-Frank—happened during his first two years when he was buoyed by his election mandate and while he enjoyed Democratic control of both houses of Congress. This time around Obama has neither of these advantages, so unless he follows the example of Bill Clinton’s second-term pivot to the center, we can expect a second term that looks similar to the relative inactivity of the past two years. At least until mid-term elections in 2014, neither Democrats nor Republicans will be able to pass partisan legislation, as the Democrats could from 2008-2010. Any significant legislation will therefore have to be bipartisan.
It is impossible to predict with certainty what an Obama presidency and divided Congress will mean for the stock and bond markets. Nevertheless, there are some instructive historical statistics worth considering. Since 1948, the performance of the S&P 500 total return index has clearly favored presidential victories by incumbents—regardless of party affiliation.
This historical trend might be surprising, but it is understandable given the market’s general preference for stability and certainty. The performance of the stock market during individual presidential administrations is also surprising, and it is worth keeping in mind when thinking about how to respond to the political landscape now. Individual presidents are perceived as more or less friendly to the stock markets, but this perception has often been at odds with actual performance. Consider the chart below. The average gain per year in the S&P 500 during Jimmy Carter’s presidency was 11.6%, which beat the average gain per year in Ronald Reagan’s first term (10.7%) and in both of George W. Bush’s terms (1.4%, -2.7%). An investor who pulled out of the market after the disastrous performance of 2008 (-37%) and in anticipation of an anti-business Obama presidency would have made his losses permanent and missed out on the recovery of 2009-2010 (26.5%, 15.1%).
These figures are consonant with the average return of the Dow Jones Industrial Average. Although the Dow has performed better on average under Republican presidents, incumbency has been a far more significant correlate with positive returns, according to numbers compiled by Forbes Magazine. In the years from 1900-2008, when an incumbent party wins the presidency, the Dow has had an average a return of 15.1%, compared to -4.4% when an incumbent party loses.
There is another data set that is particularly relevant to our present political situation: namely, historic market performance with divided political control of the legislative and executive branches. From 1961 to 2010 the best stock performance has occurred during regimes split between a Democratic presidency and a Republican Congress. Our present arrangement with a Democrat President and split Congress has historically coincided with a 7.1% average return, which is superior to the returns with a Republican President and Democrat Congress.
|Political Control||Average Return for the S&P 500|
|Democrat President/Republican Congress||+21.3%|
|Republican President/Democrat Congress||+4.5%|
|White House/Congress Same Party||+12.1%|
|Either Party in White House/Split Congress||+7.1%|
Data from MFS Investment Management & Ned Davis Research
The lesson that these figures suggest is that it would be unwise to jump in or out of the stock market based upon general perceptions about any given president’s friendliness or hostility to Wall Street. It’s simply impossible to make reasonable inferences from big picture political trends and sentiments to specific investment decisions about stocks and bonds. Such trends and sentiments are not irrelevant, of course, but they are only one factor among many other and more concrete factors that comprise the data set for prudent investing.
Right now many observers reasonably believe that political events such as the impending “fiscal cliff” will contribute to an increase in short-term market volatility. The volatility risk in the stock market may be the most visible risk that investors face, but it’s not the only or most real one. In order to escape such volatility, investors might decide to sell stocks and buy bonds. Indeed, this is what investors have been doing for some time now: from January 2008 through August 2012 $982 billion has been poured into U.S. bond funds, while $439 billion has been pulled out of equity funds. These investors have purchased the stability afforded by bonds at the price of losing out on much of the stock market recovery. From the end of February 2009 to November 2012, the S&P 500-stock index rose from 735.09 to 1427.59, which is an increase of 94%. Even with this week’s big sell-off included, which is the worst two-day loss this year, the S&P 500 index is still in the black since August 1st, and up 8.3% year to date as of Friday, November 9th.
The stability of a portfolio mostly invested in bonds protects against volatility, but in addition to reducing the expected rate of return, it entails exposure to a different form of risk, which is the risk of inflation. Even though the nominal value of a bond may be guaranteed against market volatility, a bond’s real value and purchasing power will diminish in an environment where inflation exceeds its coupon rate. Right now Treasuries yield a rate of return that is below the rate of inflation. The ordinary risk of inflation has also been exacerbated by the unprecedented actions of central banks around the world, which have been printing money through massive “quantitative easing” programs in order to spur the growth of their economies. Therefore, even if the overall risk of bonds is ordinarily lower than stocks, the central banks’ actions have ensured that ordinary rules do not apply.
To the extent that there is a historical period like the present, it may be the years from 1942-1951. At that time, like today, the U.S. exhibited features of financial repression: negative real bond yields, low price-to-earnings multiples, and high equity risk premiums. In such an economic environment, equities provide an important defensive hedge against depreciation, and this quality mitigates the overall significance of the volatility risk of stocks.
* Forward returns: the average of the subsequent five- and 10-year annualized returns for the months between March 1942 and March 1951. Stocks represented by total returns of the S&P 500 Index, which includes reinvestment of dividends and interest income. Bonds represented by a composite of the IA SBBI Intermediate-Term Government Bond Index (67%) and the IA SBBI Long-Term Corporate Bond Index (33%) from 1942 to 1951. Equity risk premium is the difference between the S&P 500 earnings yield and the 10-year Treasury bond yield. Source: Morningstar EnCorr, Robert Shiller, Standard & Poor’s, Fidelity Investments (AART) through Dec. 31, 1951.
*Gross Central Government Debt as a Percent of GDP: 22 Advanced Economies, 1900- 2011 (unweighted averages). Source: Carmen M. Reinhart, Bloomberg View
The upshot is this: markets are very complex, and hasty or partially informed investment decisions motivated by risk-aversion can actually increase risk exposure—with bad consequences.
The Fiscal Cliff
I remarked above that with a divided Congress and Obama’s unremarkable electoral mandate, any significant legislation will have to be bipartisan. The significant legislation that both parties do want to pass is a resolution to the fiscal cliff, which is the series of $600 billion in automatic spending cuts and tax increases that will be triggered on January 1, 2013, unless Congress and the President act to modify them. Now that the election is over, attention has turned to resolving the cliff, but even here the status quo remains and there are no new surprises. It is arguable that the stock market has already begun to price in the threat of the fiscal cliff, which would moderate any blow to stock prices that resulted from going over the cliff.
How serious, then, are the consequences of going over the cliff? The short-term consequences are bracing. The combined impact of tax increases and spending cuts could contract the U.S. gross domestic product by 4%, according to analysts at Fidelity, which would push the economy back into recession. Both parties want to avoid this consequence, however, and this common aim increases the likelihood of legislative compromise. Republican House Speaker John Boehner has already reached out to President Obama and on Wednesday he suggested that Republicans would make concessions as part of an overhaul of the tax code that broadened the tax base and was complemented by spending cuts. This entreaty is encouraging, even though there’s no doubt that both sides will engage in plenty of posturing down the line to try to increase their bargaining position.
Some of the tax consequences of the fiscal cliff also may be less threatening than they appear. For example, the tax rate on stock dividends is set to increase from 15% to a maximum rate of 40%. No doubt this is substantial, but it is a reversion to the historical norm, because before the Bush tax cuts dividends were always taxed as income and not capital gains. Furthermore, many dividend-seeking investors hold their stocks through tax-free or tax-deferred retirement accounts, which diminishes the impact that would really be felt if the increase happens.
If the President and Congress manage to broker a compromise before January 1st, the market could surge in response. If they fail, the market could correct sharply. Or something else entirely may happen. No one can predict the outcome, which is why investment decisions, as opposed to speculative plays, cannot be based upon political hypotheticals. The election of 2012 is not insignificant and it may prove to be momentous for many aspects of American life. Its direct implications for investors are complicated, however, and in some respects counter-intuitive. We at O’Brien Greene think that maintaining a long-term focus upon fundamental economic indicators and real shareholder value is paramount, because it’s possible to achieve knowledge about such things, and not just opinions. We know that bonds currently lose money when adjusted for inflation, and that going forward this will continue. We know that the earnings yields from stocks dwarf bond yields. These things can be measured; they offer a fixed point of reference that big picture ruminations on what can go wrong—or right—in politics cannot offer.
One concluding example of what we know: beneath the maelstrom of electoral politics U.S. companies continue to innovate. On election day, as the country was transfixed by the election, a remarkable contract was signed that is emblematic of one of the positive trends that continue to animate the economy, which is the revolution in domestic energy production. Nucor, the largest steel producer in the US, announced a joint venture with EnCana, the Canadian energy company, to build natural gas wells that will fuel dedicated steel plants. As a result of new domestic production, clean-burning natural gas is cheap and plentiful, which is transforming American industry. Factories are being built in old manufacturing towns in Pennsylvania and Iowa that have been dormant for two generations.
Matthew B. O’Brien, Ph.D.