September 2004
President Bush got his expected bounce in the polls following the GOP convention and the stock market rose implying that Wall Street is rooting for his re-election. Actually, the rally probably had more to do with traders wanting to prevent Arnold Schwarzenegger from calling them "girlie-men" on national television. This presidential race is now coming into the home stretch and we think the debates may be the determining factor in deciding who will reside in the West Wing of the White House over the next four years. Computer forecasting models are already projecting that President Bush will defeat Senator John Kerry with as much as 58% of the vote but we would not bet the Texas ranch on that result quite yet. While there are many important issues that will be decided in this election, future investment returns will probably not be much different under either administration. With interest rates rising and valuations already extended, we believe single-digit investment returns are the best that we can hope for from the financial markets over the next few years no matter who the winner is.
Democrat Presidents = Higher Investment Returns
In every presidential election year, the popular press contains many articles about whether having a Republican or a Democrat in the Oval Office is better for the stock market. Most investors intuitively believe that the stock market does better under Republican administrations because of their shared pro-business philosophies and tendencies to focus on lowering taxes and regulations. Surprisingly, history does not support that popular notion. When you add them up, stock market returns have actually been higher under Democratic presidents.
One study written up in the October 2003 issue of the Journal of Finance found that since 1927 the average annual returns for the stock market were actually 9% higher under Democratic presidents than Republican. Part of the reason for the higher equity returns was that real interest rates (after inflation) tended to be lower under Democrats so bonds were less competition for investors' money. The researchers also discovered that the difference in the returns was not due to expected business cycle variables but instead had to do with unexpected fiscal and regulatory policies brought forth by the Democratic administrations. That is, Democratic administrations have often positively surprised investors with their policy initiatives while Republicans have only lived up to expectations or have even disappointed the market.
As a recent example we recall that back in 1992 presidential candidate Bill Clinton scared the stock market with talk about higher regulations especially for the healthcare industry. However, as President he initiated programs to reduce costs for businesses and improve trade with other countries. With the help of gridlock from a Republican-controlled Congress, government spending was limited to less than the inflation rate that resulted in budget surpluses. The stock market rewarded his administration with some substantial returns during his years in office.
In contrast, newly elected President Bush disappointed the stock market with trade-protection initiatives for certain industries like steel and a willingness to increase deficit spending for popular domestic programs even prior to 9/11. These were not the kind of fiscal and regulation policies the market expected from a Republican, even a compassionate conservative one.
Recent Economic Concerns
While investors have and will continue to closely monitor the presidential race, there are many other factors that are of even greater concern. The financial markets are currently struggling with the Fed's actions to increase short-term interest rates at a time when rising oil prices and tentative corporate managers are depressing economic growth. Up until June, investors were confident in the outlook for strong economic growth. However, that confidence has eroded with recent disappointing employment reports despite Fed Chairman Greenspan's attempts to reassure us that this "soft patch" in the economy is temporary and that economic growth should accelerate in the months to come.
Our Outlook Update
In our 2004 economic outlook that we published in January, we said that we thought the U.S. economy had the potential to grow at a rate of up to 4.5% this year. That growth target was probably achievable had it not been for the spike in oil prices that hit consumers in their pocketbooks every time they fill up their gas-guzzling SUV's. We now think real economic growth will be closer to 3.5% over the next year unless there is a substantial decline in gasoline prices soon. In the early 1990's most economists, including Alan Greenspan, wished for 3.5% growth because that was considered to be the maximum sustainable rate of growth for the U.S. economy. Now they seem to be disappointed. We think for a developed, mature economy like the United States, it is an acceptable rate of growth.
We also expressed concern in our outlook about the possibility of higher inflation because of the rising global demand for all sorts of things like industrial materials and capital goods, especially in China and India. The weakening dollar has also been putting upward pressure on prices of goods that we import into the U.S. That concern has not gone away. Many companies that have not been able to raise prices in the past are now doing it to cover the higher energy and healthcare costs. This threat of rising inflation along with the increased demand for capital overseas is why we have been so conservative and defensive with our clients' bond portfolios. The Fed will continue to gradually increase interest rates to reduce those inflationary pressures. We still believe it is prudent to protect the principal of our fixed income investments with shorter maturity, high quality bonds so that we can take advantage of higher interest rates in the future.
The volatility and disappointing returns that we have seen in the stock market so far this year were not a surprise to us as we worried about the elevated levels of stock prices and the high expectations that they represented as the year began. As we stated in the January newsletter, the combination of the Fed's tightening monetary policy, slowing economic growth, and extended stock market valuations would limit the upside potential of the market as a whole. That outlook and the threats of terrorism prior to the election have kept our equity allocations for our clients' portfolios towards the lower end of their target ranges. However, we thought the volatility might also provide for some attractive investment opportunities in stocks that are beaten down for not living up to investor's expectations. We have, in fact, taken advantage of the market's wrath on particular stocks to invest in some great companies at cheap prices that have strong balance sheets and good long-term business prospects. That will continue to be our investment strategy in our effort to generate higher than average returns for our clients.
"Noise proves nothing. Often a hen who has laid an egg cackles as if she had laid an asteroid."
"Reader, suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself."
-Mark Twain
John W. Gudritz, CFA
john@frontstreet.com