As we inch closer to November 3, investors are increasingly turning their attention to the national election and the implications for the economy and stock market. Several scenarios can play out, each with potentially different results. Let's take a deeper dive:
Should the Democrats win the White House, the Senate, and maintain control of the House, this "blue wave" could emphasize taxation and regulation. If Biden wins the White House and Republicans keep control of the Senate, however, this can likely result in gridlock. If Trump wins reelection and the Republicans maintain control of the Senate, then this results in possibly the least amount of change and considered the status quo.
Policy Implications: Higher taxes on the way?
Regardless of who gets into office, there will be a lot of post-Covid cleanup to do. Hopefully, the economy moves into a recovery in 2021. Either party in office will have to find a way to pay for the massive government stimulus. In this election, the stakes are particularly high for taxpayers if the Democrats win the Senate and Biden wins the White House. According to the Wall Street Journal, "Mr. Biden has proposed to reinstate the Obama tax rates for top earners while simultaneously imposing an unlimited 12.4% Social Security payroll tax on earnings over $400,000." The WSJ goes on to report Mr. Biden favors increasing the capital gains rate to 39.6% and lowering the estate tax exemption. President Trump is avoiding increasing taxes, but someone will have pay the piper. For now, Trump's tax plan is vague and evolving. He signed an executive order deferring the collection of Social Security payroll taxes. Kiplinger's compiled a list of other possible tax cuts Trump may favor: President Trump's Tax Plan. Possible stock market and economic implications may include:
Investment Implications for Long-term Investors
This election is unprecedented in modern times — marked by the combination of a deadly pandemic, a global economic recession, and widespread civil unrest. Moving to the sidelines would be an understandable approach for anxious investors who prefer to wait and see what happens. As history has shown, however, that is often a mistake.
As you see in the chart below, in 18 of 19 presidential elections, a hypothetical $10,000 investment made at the beginning of each election year would have gained value 10 years later. That is regardless of which party’s candidate won. The only negative 10-year period followed the election of George W. Bush in 2000. His presidency saw two seismic events: the 2000 dot-com crash and the 2008 financial crisis. Even then the loss was not significant in the following 10 years. Given this, the implication for long-term investors is to avoid the short-term noise of the election and remain patient with your stock investments.
Investment Implications for Shorter-Term Investors
For investors with a shorter time horizon, there is legitimate reason for concern. Volatility in the stock market in the weeks leading up to the election and the weeks after the election is a real possibility. This may especially be true if the election is contested or is decided by the Supreme Court like Bush vs. Gore in 2000. Looking back, the VIX which is a measure of stock market volatility, spiked in the weeks prior to the 2016 election. The implication for nervous investors or those with shorter time horizons may be to heed caution now. Several solutions are available as outlined below.
What Sectors to Watch
Certain stock sectors may see a boost depending on who wins. For instance, if President Trump wins, shares of defense contractors could jump. Whereas, if Vice President Biden wins, stocks of green energy suppliers may spike. Infrastructure stocks - builders of bridges and highways - could see a boost if either party wins. Trump has made infrastructure a priority in the past and democrats traditionally favor this sector as well.
Some sectors may struggle depending on the election outcome. Companies who rely a great deal on global trade may struggle in a Trump white house if trade tensions pick up. If Biden's green agenda gets approval, traditional oil and gas stocks may slump as investors buy up renewable energy companies. Defense contractors may lose out under Biden as military spending is could decrease under Democratic leadership.
Solutions for Investors
Raise Cash Now
If an investor is concerned about losing money in the short-term, steps should be taken now to safeguard assets. Moving to all cash is one option. The question then becomes when to get back in the market? Having a plan to dollar cost average back in the market after the election may seem reasonable. However, this plan may require selling several positions depending on portfolio size. Selling will trigger transaction costs and likely capital gains taxes. If you choose this path, consider instead reallocating inside a 401(k) or IRA where there are no tax consequences.
Tweak the Asset Allocation
If going to all cash is too drastic, rebalancing or tweaking the mix of stocks and bonds is another option. Rebalancing is getting your stock and bond allocation back to the original percentages. For some clients I pare back the stock positions that have seen out sized gains this year (think technology stocks). Rebalancing consistently is one way to reduce the risk in a portfolio yet still remain in stocks.
Buy the Dips
For more speculative investors, raising cash now in anticipation of buying back at lower levels after the election is another option. The downside to this strategy is the market does not go down but may go sideways or continue to go up. At that point, it may be hard to get back into the market, as it may seem expensive or too risky. My hunch is after the November election investors will turn their attention back to the labor market and the economy. That will drive retail sales, earnings, and influence stock prices.
Gold and other hedging Strategies
Gold tends to increase in price as the stock market goes down. The problem with buying gold now is the price has already soared. Many investors jumped on the gold band wagon several months ago, so future gains are questionable.
Other hedging strategies may make sense, like being long/short. Being long means hoping the market goes up. Shorting is the opposite, hoping stock prices decrease. For example, I may be 80% long and 20% short. If the stock market collapses, the short position will profit, mitigating the losses on the long positions. Hence the hedge. A disadvantage to this strategy is the downside protection or the cost to buy a short position has increased due to the expected volatility. The increased cost makes the hedge less valuable. However, owning some long/short equity funds can still make sense as part of a diversified portfolio.
A Buffer Strategy
A buffer note is a private note issued by a large bank that provides some upside potential but limits the downside. Buffer notes are usually short-term, expiring in twelve or eighteenth months. An example of a buffer note is one tied to the S&P 500 Index, which tracks the performance of the index, to a certain extent. The upside is capped in a buffer note. If the index is up 30%, the buffer note may only pay gains up to 10%. However, the downside is limited. If the underlying index, in this case the S&P 500 Index is down 30%, the buffer note limits your downside to a certain percentage, like limiting losses to 10%. One nice thing about buffer notes is the purchase minimums are often small, sometimes as little $1,000. For more on Buffer Notes, see my blog post "Understanding Buffered Structured Notes - Capturing some upside without all the downside."
Who will win the election?
History shows that the US economy and the stock market has had major bearings on the presidential election outcomes. Since 1928, the stock market has predicted the winner of the presidential election 87% of the time, including every single election since 1984. If we get some good news on the economy in the coming months or progress toward a vaccine that may help President Donald Trump’s reelection chances. A weak economy struggling to come out of recession and a weaker stock market would likely favor former Vice President Joe Biden.
The Bottom Line
Given the uncertainty in the economy, the pandemic, and the election, the impulse to sit on the sidelines is appealing. However, in times of uncertainty, opportunity does present itself. There are pockets of the stock market with more attractive valuations than other areas. In addition, as history shows, elections typically only make short-term noise. This noise or volatility can be viewed as an opportunity to invest at more attractive prices. For those with longer time horizons, as the chart above illustrates, there are more positive 10-year time periods following elections than negative.
More important, in my opinion, are the income tax and financial planning considerations. The prospect of higher taxes seems real. Higher income and higher net worth investors need to start planning. There are several tax-smart investing strategies, charitable planning techniques, and other income and asset shifting strategies to consider. Financial and tax planning are more important now than ever.
The prospect of higher taxes seems real. Higher income and higher net worth investors need to start planning now for higher taxes to come.
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