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Nov 19, 201208:24 AMFinancial Perspectives

with Michael Dubis, CFP

The election and the markets

The election and the markets

(page 1 of 2)

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.

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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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