How might next week's election impact investment markets and the economy?. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth advisory based in Philadelphia.

Summary The market rallied again last week, raising returns on the S&P 500 by 11.3% for the calendar year to date. With mid-term elections coming up, it is interesting to take another look at the election cycle model for stock returns. The election cycle model would argue that returns for at least one of the first two years of a presidential term would be negative and that the aggregate two-year return would be barely positive. It would appear that the market will post positive returns for both years, barring a big, end-of-year decline. It is possible that the thinking of Edmund Phelps, the latest Nobel laureate in Economics, has had an impact on the breakdown of this model. On the surface, the results of the upcoming mid-term elections wouldn't seem to have big implications for the markets. At the same time, the market has risen so much recently, it could use just about any result as a reason to take some profits.

Review and outlook

According to the election-cycle theory theory of investing, this past week's stock-market rally wasn't supposed to happen. We should be seeing weak to negative returns this year. But then the election-cycle theory may have much less predictive power than in the past, thanks to the work of Phelps, the man who won the Nobel Prize in economics earlier this month.

As measured by the S&P 500, the stock market gained 0.23% last week, thanks to increases in utilities, healthcare, energy, and telecoms. Small-capitalization equities retreated a bit, with the Russell 2000 declining by 0.1%. The EAFE Index of international equities rose by 1.4%, thanks mostly to a weakening dollar.

Recent market movements could be ascribed principally to earnings announcements. Better-than-expected numbers and the prospect of the Federal Reserve halting rate hikes for a while at least had many market participants feeling pretty good.

Elections

Financial news, however, takes a back seat once every two years as news about national elections clog up the newspapers, the airwaves and, unfortunately, my mailbox. While the issues surrounding this election may differ somewhat from previous years, the election season gives politicians the opportunity to say how their actions will lift your personal welfare to greater levels and, more importantly, how the opposition is conspiring to drive this country into economic ruin and your personal situation into one of misery and abject servitude.

According to the election-cycle theory, the first two years of a president's term are generally mediocre to poor for the market. The next two years are positive over 80% of the time. This result holds whether you look at the first or second term of a president and more or less across party lines.

There is no commonly accepted reason why this cycle exists, other than what might be viewed as a common management practice. If you have the ability to decide when the economy is going to take some pain and when it is going to show some gain and make you and your party look good, you would much rather get the pain over with early so that the joy comes nearer the next election.

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So, do presidents really have that much control over the economy that they can get it to prosper or falter at their command? According to economic textbooks, the government has the ability to speed up or slow down the economy with fiscal and monetary policy.

Fiscal policy is the ability to manage economic growth by raising or lowering taxes and spending. If the government puts money into people's pockets either through tax cuts or additional spending, then they will go out and spend it and boost the economy -- or so at least traditional Keynesians believe. A supply-side economist might come to similar conclusions for different reasons: a cut in marginal tax rates gives the economy a boost because individuals have a greater incentive to work and invest their labor and capital.

The degree to which fiscal policy works and why it works is subject to considerable debate. Some argue that the benefits of tax cuts or more spending are offset by a larger deficit and the higher interest rates needed to attract the capital required to fund the deficit.

But most economists agree that U.S. presidents can rarely snap their fingers and enact a meaningful change in fiscal policy though once in a while the moon and stars line up and the president can get a desired fiscal policy through Congress. Historically, however, fiscal policies are often enacted well beyond the point where they can have a "corrective" impact on the economic cycle.

This leaves monetary policy, wielded here by the Fed and enacted by manipulating the money supply by raising or lowering interest rates. Fiddling with interest rates can in fact have a fast and powerful effect on the economy. But the Fed's monetary policies aren't controlled by the government's executive -- well, except to the extent that the president appoints the Fed's chairman, and the Fed chairman, in practice, finds it hard to avoid responding to the will of elected officials.

Elected officials have long understood the power of lowering interest rates to stimulate the economy, which is supported by research of a New Zealand-born economist, A.W. Phillips. Phillips documented a relationship between inflation and unemployment that politicians then took to extremes.

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Phillips's work argues that if you could tolerate a slightly higher rate of inflation, you would be able to reduce unemployment. Given the choice between slightly higher inflation and lower unemployment, guess which choice policymakers would be prone to take, at least before elections? This dogma reigned supreme until the 1970s. Shortly before that period though, Phelps a professor at the University of Pennsylvania, wrote a paper saying that the Phillips curve was bunk.

Phelps holds that if governments repeatedly lowered unemployment below a certain natural level at the expense of higher inflation, the ultimate result would be both higher inflation and a return to higher unemployment -- the observation that won him the Nobel Prize this year. He subsequently refined his thesis to include the idea high inflation ultimately lowered productivity and growth in the economy and resulted in an increase in the natural level of unemployment.

This turned out to be a fairly good prediction about what happened during the 1970s as poor central-bank policy achieved both high levels of unemployment and inflation. Thinking has shifted away from the idea that the Fed should manage the economy and employment levels toward the idea that the Fed's job is to manage inflation. So, when the economy slows down and prices begin to fall (deflation), the Fed should lower rates. When economy "overheats," and inflation gets too high, then the Fed needs to raise rates. This means monetary policy isn't really a tool that politicians can use to manage their approval ratings.

Pulling strings 

Now then: what control does a U.S. president now have over the economy? Fiscal policy is a difficult lever to shift, and its immediate impact is unclear. And ever since the Fed moved away from managing along the lines outlined by the Phillips curve and more along the lines argued by Phelps it hasn't been too clear how much a president can affect near-term monetary policy.

So maybe it's not too surprising to see that the election-cycle theory model isn't playing out too well this year. Last year, the first year of President Bush's second term, was an up year for stocks, with the S&P 500 rising 4.9%. This year, the second year of his term, the market is up 11.3% through last week.

Over the long run, the economic policies implemented by politicians can have a big impact. But as John Maynard Keynes pointed out, in the long run, we are all dead. Or, worse yet, from the perspective of a politician, out of office.

What's next?

Will this election have any effect on the market? On the surface, one wouldn't think so. A change in party control is likely in the House and perhaps also in the Senate. This could mean an acceleration of the expiration of the dividend and capital gains tax cut, though that's a stretch. This election isn't one, like 1992 and 1994 were, that has candidates running on some very specific plans for economic policies -- healthcare reform and tax increases in 1992 and the welfare reform and tax cuts in 1994. This time around, the issues seem to center more on dissatisfaction with the progress of events in Iraq and the perception that the Congress needs a change in leadership due to a series of scandals.

And election's victors will always try to claim a mandate to pursue certain policies. But getting these policies made into law is often difficult because a super majority seems necessary to get controversial legislation passed.

For example, president George W. Bush won the last election by emphasizing his record on national security, claiming that his opponent was a weak leader and by being the leader of a party that mounted a strong "get out the vote" campaign among his base of support. And though Social Security reform was a wide plank of his campaign platform, converting his election win into a mandate for this reform turned out to be impossible.

So if the Democrats win one or both branches of the Congress this time out, they may take "easy" targets like raising the minimum wage and allowing greater drug imports from Canada.

Still, the market has risen quite a bit over the last few months, and from a technical standpoint, seems to be overbought. It could use just about any election result as an excuse to take some profits. -FWR

Review and outlook is intended to be an unconstrained review of issues, topics and considerations of possible interest to Glenmede's clients and is not intended to be applicable to any one particular client. Actual investment decisions for particular clients are made in light of applicable considerations and may be different from the views expressed here. Likewise, actual portfolio performance may differ from the results discussed.

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