Stocks and Election 2010: Many Wildcards
The biggest concern of traders: a post-election selloff as the market has long since priced in QE2 (quantitative easing by the Federal Reserve) and a Republican victory in the House. The S&P Index has already rallied over 10 percent since the beginning of September.
Bulls argue we are entering a seasonally strong period, economic news has improved somewhat, and the Republican gains will help several key industries.
Then there's the market historians: they love midterm elections and stocks. Stock market history is stuffed full of "standard wisdom" around elections. Strategas has noted that the S&P 500 has increased in the 12 month period following every midterm election since 1942, and that the third year of Presidential cycles has seen the biggest gains historically.
But this is not a typical year, and "gridlock" may not be so great. Not only is the economy in a strange state, but if the odds prevail, this is the first time in U.S. history we will have a Republican House, a Democratic Senate, and a Democratic President. We are facing enormous budget deficits that will require a significant response from the leadership, and it is not at all clear they will be able to do so.
The biggest issue: the freeze on spending that is coming may be a game changer, so industries traditionally considered to do well under Republicans—like defense—may not do as well. In fact, most traders believe defense will be cut regardless of the power structure.
Let's look at a few other industries.
1) Energy. Here's one group that might genuinely benefit from a Republican victory. At stake are offshore drilling regulations, additional taxation, and cap and trade (considered dead). Another big issue: who regulates fracking (extracting oil and gas from rocks). It's currently regulated at the state level, but there's a move to allow the EPA to have authority over that practice...a Republican victory will likely stymie that effort.
2) Paper companies, coal companies, metals & mining companies, and utilities might see fewer environmental restrictions with a Republican victory. Auto companies might be under less pressure to implement emission restrictions as well.
3) Less regulatory involvement might also help the biotech industry, as there might be less pressure to get approval of lower cost generic drugs.
4) Big banks would likely benefit from a Republican victory...any attempt to water down the regulatory rulemaking process around the Dodd-Frank Act would be seen as helpful to banks.
There are many wildcards floating around:
1)Extension of the Bush tax cuts. Traders are assuming that there will be at least a one-year extension for all participants, but that is far from certain. The cost of a full extension will be enormous: nearly $200 billion in 2011 alone. Will that be offset with other tax increases?
If the tax cuts are extended, that would likely help consumer spending, so retailers and hotels might benefit.
2) Spending may not be completely dead...Democrats will likely push an infrastructure spending bill, which will benefit steel and building material companies. But new taxes will be needed for that...this will likely be politically unpalatable for Republicans.
3) The estate tax is scheduled to return to a top rate of 55 percent on estates over $1 million in on January 1. Some compromise would help the insurance industry.
4) Other taxes also up in the air. Higher taxes for capital gains, income and dividends for upper-income taxpayers will definitely benefit municipal bonds.
5) There is increased rhetoric around trade protectionism...with job growth scarce, you'll hear more rhetoric that free trade has cost jobs and generated few benefits. There are trade agreements with South Korea, Colombia and Panama that have languished. "[T]rade wars are possible," Tobias Levkovich, Citi's head of equity strategy, wrote in a note to clients.
6) Reforming Fannie and Freddie. The Obama administration is supposed to release its plans in January. A couple weeks ago, there were the usual howls as the GSE's regulator said it would cost an additional $154 billion to prop them up...that's in addition to the $135 billion already spent.
7) The "entitlements issue." Even with austerity the name of the game, it's doubtful there's any willpower to address it. There has been vague noises about looking at the cost of the Medicare Part D Prescription Drug Program (the newest entitlement), but Wall Street is not expecting much.
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