With only one month remaining prior to the election, markets are already discounting the effects of government gridlock. Gridlock coming by way of a Republican victory is projected to bring a changing of the guard in the legislative branch of government. To the linear thinkers (most investors), this means an indefinite extension of the Bush tax cuts. Investors have concluded that the capital gains tax rate will remain at 15% rather than 20%, and more importantly, the tax on corporate dividends will likewise remain at 15% rather than the anticipated jump to 39.6%. This line of thinking has been enough to stampede investors into a stock market rally of generous proportions. After all, isn’t a dollar of corporate dividend taxed at 15% more attractive than a dollar of interest payment taxed at 35%? Herein lies the logic behind the recent market move. Being the skeptics that we are, we see several possibilities that could easily derail this train. But more on this later…for now we’ll just enjoy the ride.
Additional fuel for the rally came from the Federal Reserve Board by way of an admitted bias toward quantitative easing (better known as printing money). Such an exercise means easy money, low interest rates and more economic growth (according to many market pundits). Above all else it means the Fed will be buying Treasury debt with these newly printed dollars; hence the firmness in bond prices.
But wait a minute! Won’t printing money bring us a weakened currency to accompany those lower interest rates? Yes, of course, and this is why the dollar is weak while gold, silver and stronger currencies like the Australian and Canadian dollars hit new highs. Administration efforts to devalue our own currency by bashing China has exacerbated this concern.
While we admit to being pleased with client portfolio allocations, we also feel rather squeamish about making money through the dismantling of our monetary system and the demise of our currency. (For clients without Australian and Canadian sovereign bonds, the likely reason for omission comes from either portfolio size or the inability of your selected broker to execute these transactions.) As to the recent strength in common stocks, we must also give credit to President Obama for his recent courtship of Wall Street and his resulting advocacy for a tax on corporate dividends of 20% rather than 39.6%. Ironically, we find ourselves giving credit and applauding this 33% tax increase rather than the 166% version.
As arcane a setting as this environment has been, our portfolio positioning is really simple, and — if I may say so — quite logical. We’ve managed to gain ground without assuming the risk inherent with a concentration in any particular asset class. Complacency, however, is the death knell for investors and we are already contemplating necessary moves should the following take place:
1. Unexpected election results.
2. Bold legislative changes such as Cap and Trade, Card Check or a tax-laden budget emanate from a lame duck session of Congress prior to the end of the year.
3. The Deficit Commission brings recommendations for a value-added tax or a change in the corporate income tax.
4. Fed Chairman Bernanke does (or does not) begin a new round of quantitative easing in order to monetize our government debt.
These are merely several of the many possibilities that could derail this market rally. For us to continue to profit without taking inordinate risk, we must anticipate and prepare well ahead of other investors. At this point, we can only surmise that our journey forward will likely be one featuring deliberate steps rather than a sprint in any one direction. We are not yet on safe enough ground to employ a long-term buy and hold strategy.
Best wishes for a healthy and happy holiday season.