Data in the US (housing, durable goods, spending and income) continue to point to moderate expansion (~2%). Headlines this year will be dominated by election year politics, and the consensus at this point is that the Republican candidate will be Donald Trump and the Democratic candidate will be Hillary Clinton. What are the implications for markets? That was one of the most common questions at our market updates this year. Questions regarding political outcomes and market outcomes are frequently asked, but seldom answered in a well thought out manner(also, policies that a candidate runs on are often far different from those that can actually be implemented after the election). With respect to the stock market, the most important policies are generally those having to do with what are known as “investor taxes,” which are dividend and capital gains taxes. These are the taxes that have the most direct impact on the stock market, and here’s why:
The value of the market depends upon the future earnings or cash flows that companies can generate, discounted for the fact that a dollar earned and received 10 years from now is worth less than a dollar earned and received today. That’s because there’s less certainty the further out in the future you look. Investors in the aggregate “set” the discount rate mentioned above. It is really investors’ “required rate of return,” and it makes allowances for things like increases or decreases in uncertainty, inflation, and taxes. Remember that investors are looking for “after tax” returns. That means the higher taxes are, the higher investors’ required rate of return will be, and the higher the discount rate will be. The taxes relevant here are dividend taxes and capital gains taxes. Think about it this way: Investors make money in the stock market by either selling appreciated stock, which incurs capital gains taxes, or by receiving dividend payments, which are also taxed. That’s why these taxes are referred to as “investor taxes.” Higher taxes on dividends and capital gains thus increase discount rates (i.e. raise the required rate of return) and lower stock market values, because future earnings or cash flows are valued less highly (i.e. discounted more heavily). But it also works the other way too, i.e., when investor taxes (taxes on dividends and capital gains) decline, the discount rate declines and market values rise (future earnings are valued more highly). Strictly applied, that means Democrats, because they are running on dividend and capital gains tax increases, would have a negative impact on markets, while the Republicans candidates, because they are running on investor tax decreases, would in theory have a positive impact. But neither of the candidates are likely to get huge changes in these taxes passed, and they are currently at historically low levels already, so I wouldn’t expect a huge impact either way.
More importantly, in order to gauge the impact of elections and proposed policies on the market, you have to know what the market has already been expecting and pricing in. I don’t think anybody really has a stock market valuation model that is good enough to tell you that, so a lot of the discussions surrounding election-year politics are kind of a waste of time. Nevertheless, here’s my stab at it (I’ll probably get into more numerical detail later in the year): Pollyvote, which combines prediction markets (e.g. betting odds), Polls (Trump-vs-Clinton), expert judgement, index models, and econometric models, gives the Democrats a 52% chance at the White House, versus 48% for Republicans. That’s a widening from pretty much an even bet near the beginning of the year. And economic data, particularly the better “nowcasting” models, suggest that US GDP is growing at an annualized rate of about two percent. So right now it looks more like the market is pricing in the election, specifically a small increase in investor taxes (dividend and capital gains), than a recession.
But of course those aren’t the only reasons for stocks to sell-off. Pull-backs and corrections are normal, and the reasons aren’t always known with certainty. Right now there are concerns over China, Europe, and Oil, just to name a few. We’ve just come away from a very anomalous period, from the Summer of 2011 to the Summer of 2015, in which the stock market rose for four years in a row without a major correction (i.e. -10% or more decline). That’s not typical - the current environment is typical.
Here’s an important closing point: the market, while forward looking, is too volatile both up and down to be used reliably to forecast the economy. That’s what Nobel Laureate Paul Samuelson meant in his famous 1966 quote, which I’m sure you’ve all heard, that “Wall Street indexes predicted nine out of the last five recessions.”
Posted on Mon, February 29, 2016
by Danny Aleman