Why Wall Street Just Doesn't Get Presidential Politics
(MONEY Magazine) – With the presidential race nearly in full swing, Wall Street is already making calls. Smith Barney strategist Tobias Levkovich suggests that if George Bush were to be re-elected, "energy companies would arguably benefit from more lenient oversight." If John Kerry wins, writes Tom Gallagher of ISI Group, "drug reimportation and other threats to the industry also become more likely," taking a big bite out of Big Pharma. "A Bush win is good for asset managers but bad for life insurance companies," declares Merrill Lynch economist David Rosenberg.
Don't listen to any of it. These kinds of recommendations--more sound bites than investment theses--reflect a crude understanding of the complex interplay among politics, policy and asset performance. After all, some of the sectors so heartily recommended for a Bush 2004 portfolio (energy and utilities) were heartily recommended by analysts four years ago for a Bush 2000 portfolio--just before their meltdown. Back then, Enron was the ultimate Bush stock. The Republican ticket was two former energy execs, Enron's CEO had received a coveted nickname ("Kenny Boy") from the headliner, and analysts saw Enron's businesses benefiting from G.O.P.-led deregulation.
The fact is, professional investors have routinely misread Washington and politics in crafting investment ideas related to political change. The question is, why?
-- STOCK ANSWERS. First, let's grant that stock strategists and analysts are (ethical lapses aside) more sophisticated than you and I when evaluating financial instruments. Their days are spent grilling sources at companies, listening to presentations and caucusing with colleagues. Then they crunch the numbers to arrive at buy, sell or hold.
But when it comes to politics--and how politics affects policy and asset classes--many analysts engage in only the most superficial research. They read the papers, listen to the same pundits you and I watch on Hardball and other shoutfests, and often accept conventional wisdom unflinchingly. In his most recent report, Levkovich seems to have based his political analysis largely on the strength of a single conference call given by newsletter writer Charles Cook. And Rosenberg recently wrote, "Washington pundits expect such a bill to include the repeal of the Public Utility Holding Company Act, which could lead to a wave of mergers in the utility sector." Hmm. Would those be the same pundits who last January anointed Howard Dean the Democratic nominee?
-- DON'T KNOW MUCH ABOUT HISTORY. For generations--since the New Deal, in fact--we've been taught that antibusiness, free-spending Democrats spell doom for investors, while pro-business, fiscally responsible Republicans guarantee solid returns. Not so. Some of the worst moments--the crashes of 1929 and 1987, the 1969-74 bear market--happened when Republicans occupied the White House. And the big bull runs of the 1960s and the 1990s came when Democrats bunked in 1600 Pennsylvania Ave.
According to the Stock Trader's Almanac, the Dow Jones industrial average has since 1901 returned an average of 6.4% a year under Republican Presidents and 9.1% under Democrats. And since 1943, writes Merrill Lynch strategist Richard Bernstein, "stocks performed better during Democratic administrations than during Republican ones, and bonds tended to perform better during Republican administrations." Stocks rose 13.6% a year on average under Democratic Presidents and 11.7% under Republican ones. Meantime, long-term Treasury bonds returned an average of 9.5% a year under Republicans and a paltry 2.8% under Democrats.
Poke through the conventional wisdom and these stark differences begin to make historic sense. There has been (and there remains) a divide between the two parties and their approaches to what politicians call "growing the economy." Broadly speaking, Democrats since F.D.R. have focused more on encouraging demand--through deficit spending, creating entitlement programs, extending unemployment benefits and boosting the minimum wage--than they have on fighting deficits or even inflation. That's generally good for stocks and bad for bonds. Republicans (at least until recently) have tended to favor fiscal responsibility, combating the evils of inflation and using interest rates as a lever to spur economic growth--a strategy that usually favors bonds.
-- CONTRARY INDICATORS. Bernstein found similarly counterintuitive results when he looked at sectors: Industrial stocks (including natural gas and oil) tended to do better under Democrats while consumer stocks outperformed under Republicans. A simple triumph of contrarian thinking? A secret Democratic love for oil drillers? A little-known alliance between the Grand Old Party and 7-Eleven?
The results are less mystifying if you simply remember that markets tend to process predictions about future results into the current stock price. Investors expect Republicans to enact policies that favor oil companies. They expect Democrats to regulate HMOs. And big investors incorporate those expectations into stocks well before an inauguration--and well before most individual investors get on board. In fact, a recent study of the 2000 race by Brown University economist Brian Knight found that the stock prices of 70 "politically sensitive" companies moved in sync with opinion polls--and that by the time the election was decided, $100 billion in market value had already shifted to Bush-favored firms.
Another example: Halliburton's stock chart. It spiked through the summer and fall of 2000 (as the rest of the market sank) in anticipation of favorable treatment by a Bush-Cheney administration. It plummeted after its former CEO was sworn in as Vice President.
-- EXPECTING THE UNEXPECTED. What's more, unforeseen events and policy shifts can change investment decisions and cause people to abandon one sector and pile into another. When good things happen for oil companies under a Republican, it's not always tradable news; when good things happen for oil companies under a Democrat, it is. Ditto for when a Republican President and a Republican Congress create a new entitlement program. In the fall of 2000, no analyst predicted that Bush and Congress would establish a vast new prescription-drug entitlement or pass a massive farm-aid bill. That helps explain why the stock of tractor maker John Deere has crushed both Standard & Poor's 500-stock index and the Nasdaq composite since 2001. It's not just that Deere will benefit from increased farm income; it's that investors suddenly decided that Deere would benefit.
In the future we should expect more such unexpected moves. Presidents are always torn between two impulses--solidifying their base and appealing to swing voters. But as bitterly partisan as things now seem, we actually live in an era of declining partisanship. A Harris poll in late February shows that 33% of adults consider themselves Democrats, 28% call themselves Republicans and 24% proclaim themselves independents. So any candidate who hopes to win a majority must appeal to voters outside his base. That's why President Clinton pushed NAFTA over objections from his labor constituency. And why President Bush, an enthusiastic free trader as a candidate, slapped sanctions on imported steel. Both moves played against partisan type--and influenced asset classes and market sectors in ways that defied analyst predictions.
-- OTHER PRESIDENTS' PROBLEMS. Presidents don't start with a clean slate. In fact, they're often voted in to clean up a mess left by another administration. F.D.R. inherited a depression that called for policies to reinflate the economy. Good for stocks (the S&P 90 returned 33.5% a year in his first term); bad for bonds. Ronald Reagan inherited high inflation from Jimmy Carter--the federal funds rate hit 19% in the spring of 1980--and pursued policies that fought inflation. Good for stocks; even better for bonds, which benefited from the significant decline in interest rates during Reagan's first term. The point here: Even if Presidents get elected on specific platforms, leftover obligations often keep them from following through.
It's hard not to conclude that the quadrennial sector bets Wall Street produces are little more than entrail reading. Amid all the talk, a key fact is ignored: Most political events have little impact on most companies. Between Jan. 1, 2005 and Jan. 1, 2009, the stocks that post higher profits, pay larger dividends and offer better growth prospects than their peers will beat the indexes--regardless of which Yale graduate resides at 1600 Pennsylvania Ave. --DANIEL GROSS