Elections and your investments

One of the investment mantras I remind my clients of most frequently is that the stock market is, above all else, a "discounting mechanism." What that means is that it is constantly in the process of pricing in today what it believes will happen in the future. Brilliant value investor, Benjamin Graham, put it this way: "In the short term, the stock market is a voting machine; in the long term, it is a weighing machine." Translated into laymen's terms, the stock market acts today based on the emotions and psychology of investors, but ultimately, it acts based on the earnings of its companies.

I shared these investment principles because the market is certainly pricing in now the various possibilities that exist in this year's election. Many people have wondered if the market will react negatively to a Barack Obama victory, particularly as he has campaigned on a message of increasing the capital gains tax on investment profits. While it is indisputable that both the capital gains tax cut and dividend tax cut of 2003 have been very favorable for stock portfolios, I would also argue that the market has already priced in (at least partially) the possibility that those tax cuts are in jeopardy. In fact, based on the national voting mood and polling data, the market has probably priced in not just the possibility of an Obama victory but the probability of one.

But many issues warrant consideration besides each candidate's view of capital gains taxes and dividend taxes. For individuals making between $100,000 and $200,000 per year, Obama may claim that he will not be raising marginal income tax rates, but he is promising to increase the amount of income that would be subjected to FICA (Social Security) taxes. Currently, the first $102,000 of an individual's income is subject to this tax (6.2 percent), but should it be increased to $200,000, that would represent a marginal, hard-dollar expense to millions of people. Savings and investment plans may need to be adjusted significantly.

Additionally, a great deal of estate planning has been done with certain assumptions about what the laws will be in a new administration. A massive policy change could have big effects on things you have put into motion. If the laws providing for "step up in cost basis" of your investments (at your death) were altered or repealed, you would need to take a good look at the things you are doing in your portfolio. If the estate tax exclusion (the amount of your estate that would be exempted from estate tax) were lowered, that too would likely warrant additional planning or modifications. Both of these changes are very likely to be on the agenda of an Obama administration.

My own belief is that it is far too early to know what will happen in the election this November. Many have rightly pointed out that in the last Democratic-controlled White House (Bill Clinton's two terms in the 1990s), the stock market experienced unprecedented growth. That period also featured significant reductions in capital taxation and the largest increases in global free trade the world has ever seen. I think a discussion of what the market will do in November of this year is unhelpful.

If Obama is the victor, I think the market will have already priced many of the implications in. Should McCain score an upset victory, perhaps the market will rally substantially as it did in late 2004 when President Bush defeated Sen. John Kerry. But far more important than the short-term effects of a presidential election result is Benjamin Graham's "weighing machine" of earnings. This November will not make or break any aspect of the capital markets. But to the extent that policy and philosophy will affect the future earnings of businesses, there is much to watch.