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Nov 19, 201208:24 AMFinancial Perspectives

with Michael Dubis, CFP

The election and the markets

The election and the markets

The election is finally over. The Obama win was predicted for some time and doesn’t come as a surprise to me. Intratrade, the stock market, and Nate Silver (The New York Times) all predicted an Obama win. If you want to save yourself some valuable time in the future, those three sources have the highest prediction reliability for national elections. The first two have money on them, while Nate Silver has one of the best statistical methodologies out there.

What comes as somewhat of a surprise to me, though, is how volatile the stock market has become in reaction to the win and the fiscal cliff. The key indicators pegged Obama to win, but the market is still experiencing a big drop over the past month. My guess is that the market is NOT reacting to “just the Obama win”; rather, it is most likely reacting to a combination of knowns and unknowns.

The stock market

When the market moves 2% to 5% in a month, I honestly don’t think much about it because it’s relatively common throughout any given year or market cycle. Those pundits who would have you believe otherwise are either feeding on your fear or are simply historically illiterate.

Upon review, it seems the following are driving the downswing:

  1. The eurozone is front and center again. This is hard to find in U.S. newspapers/apps, but if you turn a few pages, you’ll read that the entire eurozone is still very much a risk.
  2. Uncertainty surrounding the fiscal cliff. As many of you know, if a budget isn’t established, there will be a mandatory $600 billion in spending cuts and tax increases in January. See “What is the Fiscal Cliff?” The size of this problem suggests that it is likely another dial mover, but the idea of the fiscal cliff is not a mystery to the markets. “How” it will play out, though, is.
  3. Uncertainty surrounding tax law changes. It’s possible the capital gains and qualified dividend rates could rise and possibly rise considerably. If that happens, dividend-paying stocks will get hit hard (or are possibly already “hit”) to address the fact that after-tax returns on those stocks will go down. So many people are chasing yield these days (See my blog post from last month on this topic) that any bump in the after-tax return will certainly have an impact on the markets.

Of the items above driving markets today, the one that is the most concerning to me is the potential for radical investment tax law changes. This is highly uncertain and difficult to pin down. I don’t think it should be catastrophic, everything else held equal, but it would not be unreasonable to see a 5% to 10% correction to account for the loss of after-tax wealth if the tax law changes unfavorably.

Every moment of the trading day, the stock market is a barometer of future cash flows discounted by the market’s required rate of return. The market today is assuming that both cash flows will be lower, while the risk appears to be higher. That opinion changes every nanosecond and every day.

In the long term, the stock market is made up of millions of people directly or indirectly striving to work toward a better place five, 10, or 20 years from now. Assuming these folks are able to do that, the stock market rewards them for waiting that long.

 

The economy and what to do now

I try not to spend too much time thinking about complex futures. I read Future Babble a year ago and that has convinced me that spending too much time on prognostication is a waste of time, and that real value is spent building a plan around multiple possibilities and then course-correcting as life changes. No one can navigate complex futures with high levels of certainty, and overthinking these issues often leads to paralysis by analysis – in other words, you will never build a plan.

Taking too aggressive of a position one way or the other will, with a high degree of probability, lead to an irreversibly damaging result if one is wrong. This has been the case for many people who, over the past four years, assumed Obama would hurt the economy and stock markets, while bond yields would skyrocket. Four years later, the stock market is up over 100%, housing has either bottomed or started to recover, and bond yields are at historic lows.

There’s great debate as to how we got here, who is responsible for this, and whether it will last, but the fact remains today that many folks who took radically conservative positions with their plans four years ago are in irreversibly damaging positions today, just as those who took radically aggressive positions from 2005 to 2008 are in irreversibly damaging positions as well.

Those who took a “diversified” worldview no matter what the “diversification” level was (i.e., portfolio, financial plan, jobs, etc.) did far better than those with no plan. Through time, it has always been this way. I’m not sure who said this, but “even a bad plan is better than no plan.” Having no plan means you will react and may make poor decisions. A bad plan, at least, is proactive and will still get results. And if you’re prudent enough to make a good plan, you’re only going to be that much better off.

Our future, though, is like no other because we’re in uncharted territory. We’ve accumulated more debt in the last six years than in the entire history of our nation. We have to unwind some of this. Constituents and politicians alike don’t really understand how to address this “complex future” either, and even if they wanted to come together, it’s understandable that there will be struggles along the way.

We’re facing possibly decades of deleveraging along with promises to entitlements that we simply can’t afford to cover in their current form. This is a national math problem. The math has to be solved at some point in the future by everyone.

Individual planning works, though. You don’t have to be in a race to the bottom. You have time to consider what these possible changes mean to you and how you want to plan around them in a positive direction.

Michael Dubis is a fee-only certified financial planner and president of Michael A. Dubis Financial Planning, LLC. He is also an adjunct lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at financialperspectives@gmail.com.

This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services described in this website or that of the author’s. Mike Dubis does not guarantee the relevancy, appropriateness, or accuracy of any outside information or links. Mike Dubis does not render or offer to render personalized investment advice or financial planning advice through this medium. All references that might be made to an investment or portfolio's performance are based on historical data and one should not assume that this performance will continue in the future.
THIS COMMUNICIATION MAY NOT BE USED BY YOU AS A RELIANCE OPINION WITH RESPECT TO ANY FEDERAL TAX ISSUE DISCUSSED HEREIN AND IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY YOU FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON YOU BY THE INTERNAL REVENUE SERVICE.

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Old to new | New to old
Nov 20, 2012 03:15 pm
 Posted by  John

I don't think the downturn is nearly the mystery you make it. It clearly has to do with the expected tax consequences of a renewed term for this administration that has repeatedly advocated rolling back Bush (now Obama) tax relief measures with increased personal (S Corp) and dividend taxation. The natural response has been a sell-off of equities, before the expected changes go into effect.

Nov 23, 2012 11:50 am
 Posted by  Mike Dubis

Hi John,

Thank you for contributing. I believe that's basically what I said.

Although I don't agree that it's "clear." If one could tell me exactly what the expected changes are in the tax code, we could conclude part of the impact, but markets are too chaotic to assign to one factor.

There are other issues, including yours, as well that are driving markets:

1. Earnings are coming in much weaker.
2. Eurozone ambiguity is bigger than the tax code ambiguity.
3. The markets were up 17% ahead of the recent correction; retraction is inevitable at some point.
4. Quantitative easing is not having as much of an impact.
5. Apple is down 20% from market-peaks; being the largest individual holding of most large cap and hedge funds, it has a dramatic impact on markets.

All of these items and then some, drive value.

Best,
Mike

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It is an understatement to say the world has experienced a radical shift in capital markets. There are more layers of information and opinions on the direction of the world than we've seen in decades. The internet and the media do not always make it easier, but Michael Dubis' contribution through IB blogs will help you sift through the noise and give you some perspective. You can find his company online.

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