| Parallels with 1994 - The Implications of the Election for the Stock Market I believe that there may be significant potential implications for the stock market of what I view as parallels between the outcome of this election and the surprising Republican Congressional majority resulting from the election of 1994. As you may remember, ten years ago the major averages were basically flat and traded within a relatively narrow range for most of the year before that election, just as they have done for the majority of this year. Then, immediately following an election which was even more stunning both to the national media and also to financial market participants, the stock and bond markets both staged strong rallies which found many market participants underinvested. (Remember the worries about Hilary Care, budget deficits, aftermath of systemic financial problems, seemingly slow economic growth, etc.) In retrospect, those rallies were in fact the real start of the ‘90’s leg of the long secular bull market; investors who remained skeptical and/or waited for pullbacks missed a huge move before the first significant correction occurred in 1998 during the political crisis caused by the Clinton impeachment proceedings. I would first like to discuss why I believe that my hypothesis is correct regarding the similarity of the political backdrop for the markets. I will subsequently discuss other differences and similarities between that period and the present situation. I will begin by attempting to address the political similarities. There are many ways in which this election can be viewed as equally significant when compared to 1994. First, while the unexpected outcome of that election was the first indication that the balance of political power in the country might be in the process of undergoing a dramatic transformation, this election may provide to be the completion of the assembly of a new governing coalition. (For confirmation, just look at the red vs. blue states; then envision an overlay of areas gaining and losing population.) . Second, the Republican Party now has working majorities in both houses of Congress not dependent on its own liberal members. Third, the dramatic shift in the Senate, when Reagan was elected there were 20 Democratic senators and 6 Republican senators from the 13 Southern states. There are now 22 Republicans and 4 Democrats. There appears to be a clear a natural majority for the Republican Party; much to the dismay of most pundits, the high turnout actually aided Republicans. This is not meant to be a commentary on the validity of Republican/conservative ideas (as many of you know, I agree with some, but far from all, of their policy positions), but rather an observation that neither George Soros’ money or the media advantage of Kerry could stop a pretty convincing victory for Republicans. (The liberal Evan Thomas of Newsweek estimated the media advantage to be worth 15 points – if you doubt this just look at the now public story Newsweek released about the Kerry- McCain negotiations for veep.) The constituents of this majority basically fall into the two major complementary categories of what I will characterize using the much overworked shorthand catch phrases of the “leave us alone” coalition and the “evangelical” bloc. These two groups seem to be more likely to coexist given their distrust/dislike of an activist government than do the largely conflicting elements of the Democrats’ power base which could not coalesce to win the election for Kerry despite the fact that they were bound together by their hatred of President Bush. In many ways, the agenda of Dubya is at least as far reaching and potentially transformative as was the Contract with America. Look at the specific major areas of intended domestic reform – social security, the legal system, healthcare and education. All these tied together by the interrelated themes of ownership and opportunity. Remember, Bush has emphasized that he has every intention of spending his political capital in pursuing his agenda. Now I will attempt to briefly summarize the major differences with 1994; this summary will be followed by a few observations regarding why these differences may not matter for the market outlook. Of course, the War on Terror (broadly defined to include Iraq) and its potential disruptive effect on our economy is clearly the most worrisome and unpredictable factor. Allied to this but far from synonymous with it is the potential for significant supply/demand imbalances in energy markets. The third is the change in economic policies and rapid development of many underdeveloped countries, most notably China and India. The fourth is the much higher absolute valuation levels on most metrics. (Under reasonable assumptions only emerging markets probably can provide truly superior long term returns from these levels for either equities or debt instruments.) Fifth is the fact that 1995 was the third year of a presidential term (usually the best for the stock market), and Clinton changed direction pretty dramatically. On the other hand, 2005 is the first year of the president’s second term, usually the worst year for the markets, particularly when they are fully valued. Sixth is the worrisome signal of potential inflationary pressures currently being flashed by the price of gold and weak US currency. Last, the fact that there are perhaps arguably worse fiscal imbalances in the government and consumer sectors of the economy. Most importantly, since terrorism is the biggest uncertainty, I believe that the lack of a major terrorist act here is an indication that Al Qaeda has been more seriously damaged than many people believe. One piece of evidence is their failure to disrupt the Afghan elections despite repeated threats. (At one time pundits thought turnout would be 3-4 million voters, it was over 10 million.) Of course, I am not naïve enough to think that there won’t be any further horrific acts, but if the elections in Iraq are held on schedule and are successful, it will be a major blow to their credibility. Note carefully, Usama’s tape was a threat rather than a warning. Al Qaeda has never warned of any attacks or actions; when they are strong enough to take action they kill and maim and destroy in their nihilistic fashion. (E.g. attacks aimed at Spain and Australia before their elections.) When they are weak and frustrated they threaten in an attempt to terrorize their enemies. If Arafat’s death results in a positive change in Palestinian leadership, Al Qaeda might become much more isolated in the Middle East. As a broad generalization, I believe that the negativity regarding many of the above factors may lessen over the next twelve months. On an intermediate basis, energy prices seem to have a major uncertainty premium embedded in them; likewise with the economy looking stronger and worries among businessmen about the election outcome removed from outlook, the Federal Reserve may be more willing to continue to remove excess liquidity from the financial system. While this could have a temporary dampening effect on stock prices, it would be another factor that could sustain a long period of sustained economic growth. Finally, if the recent trend for government spending to increase as a percentage of GDP can be halted and eventually reversed by a president less cautious about vetoing spending bills, the dramatic productivity increases of the past decade will be likely to continue. Thus, there appears to be the potential for strong momentum in GDP growth and corporate cash flow. Importantly, if the President successfully implements several of his initiatives (particularly tort reform -very high probability) and social security reform (high probability of some reform, moderately high that it will be meaningful), the impact on the GDP growth trajectory could be quite dramatic. Since valuation levels are very sensitive to changes in the trend (or normalized) assumptions for growth and profitability, it is certainly possible that sometime during the next twenty four months a consensus might emerge that equities are not as highly valued as they currently appear. My purpose is to use this piece as an efficient way to communicate my initial take on the 2004 election. I wanted to use this opportunity to reinforce the fact that I think this election might be a significant inflection point for the market, especially since so many firms and institutions have adopted hedging strategies which preclude them from fully participating in any large and sustained market advance. Such positions will become increasingly uncomfortable if there is a sustained rally, as there was not only during 1995 but interestingly enough as there also was during the first year of the Clinton second term despite the odds against such an event. As an addendum, I actually believe that the largest political risk to the Bush agenda is the potential for a fight of monumental proportions when the first Supreme Court vacancy occurs. I hope for the sake of our country that this does not occur, and that the administration does not misinterpret the nature of their “mandate”. The timing of Supreme Court nominations and choice for Chief Justice will be crucial; unfortunately the medical prognosis for Chief Justice Rehnquist’s condition does not sound encouraging and potential battle lines are already being drawn. Tucker Andersen November 6,2004
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