What History Tells Us

Does the stock market fare better under a Democratic Administration versus a Republican Administration?

Answer: No--saying it does mistakes coincidence as fact. Read on.

Expect the economic arbiters charged with officially calling economic slowdowns to announce after the election that we are in a recession.

October is always the toughest month of the year for the stock market, it's historically the month when the majority of the stock market crashes and the bottoms have occurred, David Wyss, chief economist of Standard & Poor's has noted.

But investors can take heart. There's a case to be made that the markets will turn around by the second half of next year.

The economy is looking like circa 1974, when it declined for 16 months or so. The stock market recovered about five months earlier than the economy did. If you figure that the downturn began last March with the implosion of Bear Stearns, that means the market starts a possible turnaround in February of 2009.

Broadzoom picture: the International Monetary Fund estimates the percentage of the world's population joining the middle class will increase anywhere from 30% to 40% by 2012. And when you hear recession talk, keep in mind that the US economy has added the equivalent of the GDP of China, of two Canadas and five Saudi Arabias since 2003.

Election year bear markets are common, for example, they occurred in 2000, 1984, 1980, 1976, 1968, and 1960, as Fox Business editor James Kingsland points out.

But they usually coincide with a change of the party occupying the White House. Since 1960, only Reagan withstood an election-year bear in 1984.

Economists such as Edward Yardeni says President-elect Obama's "inaugural address will be reminiscent of FDR's first inaugural speech on March 4, 1933, when FDR promised to expand the power of the government to overcome the economic crisis back then."

Yardeni adds that "in his State of the Union, Obama will say that he has learned the financial and economic situation is much worse than we were led to believe by the Congress will recommend a sweeping program of fiscal stimulus. It will also be designed to significantly redistribute income and wealth. Liberals will love it. Conservatives will hate it."

It's Been Painful, But a Light is Seen

World equity markets lost an estimated $5.79 tn during October, the biggest monthly loss ever, Standard & Poor's Index Services says.

The October loss eclipsed the previous record, which was set just one month earlier, when 52 global equity markets lost a combined $4 tn.

Through the first 10 months of the year, world markets have lost about $16.22 tn, according to S&P research.

Though U.S. markets accounted for nearly 40% of the losses during the month, they performed better than the average world market, S&P says.

Problems Still Ahead

The incoming Administration will have to contend with severe economic problems, including massive federal budget deficits, out-of-control Supersize-me government spending with tax dollars blown out to sea, a bankrupt Social Security and Medicare system, rising healthcare and tuition costs, the list feels ad infinitum.

Does Divided Government Matter?

But the idea that the stock market fares better under a Democratic administration is misguided. The argument does not take into account the lag effect, for example, of tax cuts and interest rate cuts.

And the notion that a divided government, with one party in control of Congress, the other the White House, imposes discipline, frustrates legislative zealots and keeps spending in check and the deficit down--the stock market wants economic stability--mistakes coincidence for cause. And bogeymans about a unified government's effect on stock markets are just that, phantoms.

Look at history:

*The S&P 500 returned 16% under Harry Truman, when the government was divided and the deficit worsened;

*It rose 12% under John F. Kennedy, when the Democrats controlled Congress;

*The S&P 500 returned 10% under Lyndon Johnson when government was unified and spending soared, worsening the deficit;

*The S&P was up 0.6% along under Richard Nixon, when government was divided and deficit problems were still worsening;

*And it returned a sweet 17% under Gerald Ford when government divided and the deficit worsened, when the Democrats controlled Congress;

*S&P was up 11% under Carter, when the Dems controlled Congress;

*S&P was up 14% under Reagan, when the government was largely divided;

*S&P was up 14% under George H. W. Bush, when the Dems controlled Congress;

*It rose 17% under Clinton, when government was largely divided.

Cart Before the Horse Thinking

When Clinton was in the White House and the Republicans ruled Congress, the US saw soaring surpluses and a rising stock market.

But was that economic boom due to a lag effect from Ronald Reagan's tax policies? George H.W. Bush's continuing the US's tough stance on Communism? Did Clinton enjoy a post Cold War peace dividend, which caused his administration to cut defense spending and enact welfare reform?

Did the market start to take off under Reagan not just because of tax cuts, but because the Federal Reserve kept interest rates high to combat double-digit inflation? From Reagan's January 1981 swearing-in to year-end, the Dow slid 8%. It then rose 135% by the end of his term.

The Dow's robust performance under Clinton was not just due to the lag affect of the Reagan tax cuts, but also because the Federal Reserve was hyperactive in cutting interest rates to record lows, creating two successive bubbles, analysts maintain. And remember, Clinton skewed to the middle and adopted pro-market policies advocated by Republicans, including signing into law a cut in the capital gains tax in 1997.

It's been argued, too, that the deficit fell under Clinton because rich people started to pay more in taxes, and because the dot.com boom, fake as it was, created a surfeit of income and capital gains tax revenues. The cuts in the capital gains tax and estate tax delivered more to the Treasury than Clinton's income tax hike on the top bracket, some experts note.

No Spending Control

Spending control has been largely non-existent since the '60s.

Remember, Ross Perot won 19% of the 1992 vote campaigning as a deficit hawk. With all the election spending promises you are hearing now, I am mindful of this phrase: "Politicians are the same all over. They promise to build a bridge even where there is no river," says Nikita Kruschev.

Some of the worst deficits (more than 3% of GDP) came under divided government. Think Nixon, Harry Truman in 1948, Gerald Ford, and Ronald Reagan.

Remember, the economic recovery acts passed under Reagan were loaded with giveaways that inspired phrases like Gucci Gulch, denoting the well-heeled lobbyists in Washington, D.C. clamoring for gimmes.

However, some of the biggest increases in spending over the past half a century occurred under unified government--LBJ and Bush (in the first term, split in the second), while the smallest increases have occurred under divided government (Eisenhower and Clinton).

The Dow fell during the Nixon administration (down 16.5%) and under George W. Bush. The best post-World War II performance came under Clinton, with the Dow up 226.6%.

What the Market Really Cares About

The stock market really cares about corporate earnings and interest rate cuts.

Interest rates are at historic lows. The three-month LIBOR rate, (the London Interbank Offered Rate, which banks use to peg rates to), dropped to 2.71%, its lowest point since June 9. The Fed funds rate is at a low of 1%.

But corporate profits are still sagging quite badly. Profit results for the 1,837 companies tracked by the Wall Street Journal that have reported third quarter earnings so far shows profits are down 42% versus the third quarter of 2007. Economists like Yardeni expect the S&P 500 earnings results to steadily deteriorate through the first half of 2009 and recover weakly in the second half.

He expects S&P 500 year-to-year earnings growth for 2008 to drop 9%, but come in a weak 1.4% for 2009.

Where We Are Now

Again, analysts are starting to put out the rallying cry that the stock market will recover in 2009. Interest rates are at record lows, with the federal-funds rate at 1%.

Fiscal stimulus and the government's bailout money is already sluicing through the system, but a liquidity trap is at play, with banks not lending that money (see below). There is a reason that the market is a leading economic indicator, because stocks historically recover before recessions end.

Historically bear markets, according to S&P 500 stats, on average lasted 19 months after a 34% decline. It took investors who had invested in the stock market just before the 1929 crash 13 years to recover all that was lost.

In 1980, 1987, and 1990 the S&P was up by at least 20% just six months after the market bottomed out.

The Banks' Liquidity Trap

What are the nation's commercial banks doing since the government's bailout? Economist Yardeni notes that they are piling into liquid assets since Lehman filed for bankruptcy on September 15. Yardeni says that over the six weeks since September 10:

(1) Their cash assets rose $263 bn to a near record $549 bn.
(2) Their US Treasury and Agency securities holdings jumped $140 bn to a record $1.3 tn.
(3) In other words, their liquid assets are up $403 bn over the past six weeks to a record $1.83 tn.
(4) Bank loans are up $347 bn over this six week period. Note that this includes a $210 bn increase due to the consolidation of nonbanks into large domestically chartered commercial banks.
(5) Banks borrowed $353 bn over this period, led by $280 bn borrowed by large banks.

Yardeni also says that Fed stats show that deposits at the central bank by all depository institutions (including the banks) rose to a record $426 bn on October 29, up a whopping $394 bn since September 10. Over the same period, the Treasury's deposits at the Fed rose $573 bn to a record $578 bn.

He says that while the private sector is rapidly deleveraging, Freddie Mac and Fannie Mae are just as rapidly becoming increasingly leveraged. The two are now the world's largest hedge funds, Yardeni says, "with a guaranteed source of funding from the world's largest prime broker, namely, the US Treasury."

Economic Outlook

Yardeni forecasts first and second quarter declines of 2.0% and 0.8%, respectively, next year. The peak-to-trough decline in his scenario for real GDP is 1.8%. That compares to the average peak-to-trough decline of the seven recessions since 1960 of 1.7%, he notes.

Policymakers around the world "have already started to implement a Global New Deal II," economist Yardeni says. "They are moving rapidly to provide as much policy stimulus as possible. Central banks are cutting interest rates. Government spending is increasing." His proof:

(1)The Reserve Bank of India on November 1 lowered its benchmark interest rate for the second time in two weeks, and reduced the amount of money lenders are required to keep in government bonds for the first time in 11 years.
(2) China's central bank removed temporary controls over loans to maintain, three days after cutting its key rate on October 29 for the third time in two months.
(3) Both China and India are preparing to increase government spending to revive growth. China's Purchasing Managers' Index fell to 44.6 in October, the lowest reading since this measure started in July 2005.
(4) South Korea plans a 14 tn won ($10.8 bn) boost to the economy next year. The package includes spending an extra 4.6 tn won on regional infrastructure and provides 3 tn won in tax benefits, mainly extending tax breaks on investment in factories.
(5) French President Nicolas Sarkozy last week pledged to add 100,000 government subsidized jobs in addition to 230,000 subsidized positions already planned in the 2009 budget. He has pledged to buy more than 30,000 unfinished homes, put on hold a tax on business investment, and create a sovereign wealth fund to invest in French companies that could become targets of foreign "predators."

Global Stock Markets Respond

Stock markets around the world are already starting to respond positively to the Global New Deal II, Yardeni says.

The MSCI World Index plunged 47.8% since its record high on October 12, 2007 through October 27.

Since then, it is up 12.9% through October 30. The MSCI Emerging Index is up 18.4% since October 27, with Latin America up 23.1% and Asia up 14.8%.

The MEI stocks, which were clobbered in recent months on fears of a global recession, should benefit most from Global New Deal II spending on infrastructure, Yardeni notes.