Farr: Election No Panacea

Candidates in this year's mid-term Congressional elections have spent record amounts of money in what many believe will be a transformational election.

Why transformational?

Because voters are widely dissatisfied with the leadership coming out of Washington, and they are looking for change.

We need only look at the latest Consumer Confidence readings (which are hovering around 50 compared to the 10-year average of 88) to get some gauge of the current level of pessimism. "Twice as many American voters prefer a first-time candidate to someone who has served for more than a decade," wrote Laura Meckler of the Wall Street Journal, quoting results from a WSJ/NBC poll this month. The same poll in March of this year found that half of all respondents would replace every single member of Congress if they could. We think you'd have to go pretty far back in history to find this level of antipathy toward the government.

As a result of the dissatisfaction with Washington, Republicans are widely expected to gain the requisite 39 seats to take control of the House. In the Senate, Democrats are expected to maintain their majority but by a smaller margin. In anticipation of such a Republican victory (as well as additional quantitative easing by the Fed), investors have sent stock prices soaring. The S&P 500 is up nearly 16% since the year's low on July 2, and the gains seem to keep coming.

Alexandra Grablewski | Riser | Getty Images

Investors are sending a pretty clear message: stop the reckless spending and lower our taxes.

They want an extension of the Bush tax cuts across all income levels, and they want no new major policy initiatives (read: more spending) that would further increase the already massive budget deficits.

Voters seem to believe that a split Congress and increased gridlock is the best way to achieve these ends, and I don't disagree.

But to suggest that more Republicans on Capitol Hill will be some kind of panacea for the economy and the stock market is simply delusional.

Are investors ignoring the policies that contributed to a 75% rise in the major market averages since the March 2009 lows?

In our view, the massive rally off of the March 2009 lows was fueled by a flood of government support, including massive and unprecedented support for the housing market and banking industry, ultra-low interest rates, and the promise of low taxes out into the future. Yet despite all that has been done, the economy still does not appear to be growing on a self-sustaining basis. Mortgage rates are near 4%, but the latest readings from Case-Shiller suggest housing prices may be falling again.

Banks are not lending despite several hundred billion in new equity capital that was raised in an effort to strengthen their balance sheets.

Businesses are not hiring new workers because demand isn't there, credit has been cut off, and uncertainty abounds with regard to future tax rates, regulations and healthcare costs. Is a change in control of the House realistically going to fix all these issues?

The reason we are not out of the economic woods yet is because the government decided that rather than face an acute and painful recession in the near term, it would be better to spread the pain out over a long period of time.

After addressing the immediate crisis of a collapse in the banking system (which we applaud and which had to be done either way), Geithner, Bernanke, Obama et al made a concerted decision that unemployment could not be allowed to go too much higher, and housing prices had fallen quite enough.

The result of this decision was a $787 billion stimulus plan, the purchase of $1.5 trillion in Treasuries and MBS by the Fed, and the nationalization of Freddie Mac and Fannie Mae (among much, much more). These actions led to a number of very swift and positive outcomes, including a normalization of the credit markets, stabilization of the housing market, very low interest rates, improving corporate profits, and yes, higher stock prices.

Your Money Your Vote - A CNBC Special Report

But our continued economic problems reflect a need to go through the process of deleveraging.

The government's stop-gap measures designed to halt rising unemployment and falling housing prices did nothing to address this issue. In fact, it could be argued that the government's policies are contributing to the long-term problem of over-indebtedness.

What the government's actions did do, however, is support asset prices.

As the economy stabilized and interest rates plummeted in response to government action, investors were forced into risky assets in an effort to generate an acceptable return on their money. Stocks, bonds, commodities and real estate all caught a bid as the Fed flooded the system with dollars. And this continues today as the prospect of further quantitative easing erodes the value of the dollar.

Investors increasingly believe that government is hindering rather than helping the economic recovery. While I agree that the Fed could be in fact compounding our continuing long-term economic woes, I also believe that the Fed, to a certain extent, is responsible for the latest stock market rally we are enjoying. If investors believe that a Republican Congress is going to magically make our debt issues disappear, we fear they are sadly mistaken. The extension of the Bush tax cuts is undoubtedly a positive, but any moves toward fiscal austerity may pull our pain from the future into the present. Without arguing whether or not this is the correct course of action, we would just say that investors should be prepared.

Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.