The election is over. While we slept, there was a three-hour respite between the election being called and the wee morning hours of the next day when there was no news. But since then, the nation’s attention has turned from the campaign battle to the ominous “fiscal cliff” talk that will dominate the headlines until the end of the year. Market observers and economic analysts are trying to predict what compromise Congress might come to in the coming months and how it might impact markets and the economy.
In the two days following the election the market has sold off a little over 3%. Is the recent market drop due to President Obama winning the election? And if so, does that mean the drop will continue? It was widely believed that the markets had priced in an Obama win, so it should not have been a surprise to the markets. The morning after the election Germany announced that its economy was showing signs of a slowdown, something that also rattled markets. It is unclear to what extent the market sell-off has been directly caused by Obama’s re-election. What does seem probable is that the uncertainty over our tax and spending policy will lead to increased market volatility in the near-term.
The re-election of Obama means a greater probability of higher tax rates on high income earners. For taxpayers making more than $250,000 (married filing jointly) these taxes would be applied to not only earned income, but passive income as well, such as dividends, interest and capital gains. Fear of higher future capital gains rates could be contributing to a short-term sell-off. In addition to higher rates, high income earners will see a 3.8% Medicare surtax on passive income as well. There is concern that these higher rates, coupled with spending cuts and expiration of the payroll tax holiday, will lead to economic slowdown.
On the upside, political commentators believe that a positive for the market is that Obama is likely to keep Ben Bernanke in place, giving more certainty to Fed operations. The current easy money policy should continue and interest rates will be kept low for the next year or so. Low rates usually are a positive for stocks and for real estate. Also, if higher inflation is an eventual consequence of these low rates, stocks and real estate will serve as an inflation hedge.
The so-called fiscal cliff is another matter that the market is grappling with at the moment. At the end of the year the Bush tax cuts expire and large spending cuts and tax increases that the 2011 Congress imposed will take effect. Most people believe that Congress will come to some type of compromise to avoid such severe measures. The interim between now and when a potential agreement is made could be a volatile time period for the market.
The closer we get to the deadline without a decision, the crazier it will make investors. Not knowing the outcome could be worse for markets than knowing the outcome, whatever that may be. Just coming to an agreement on the fiscal cliff alone may send stocks higher. In the meantime, it warrants some guidance to hang on to your hats, but also caution against making radical portfolio changes. The stock market shuddered, too, at the looming debt-ceiling crisis of 2011, dropping nearly 16 percent in the weeks prior to, and immediately following, the agreement to lift the debt ceiling. About six months later stocks had regained all that ground.
If your portfolio is invested to suit your risk tolerance and financial situation, there are most likely no changes that you need to make at this time. When investing with long-term goals in mind, the rocky play of politics against short-term movements of stocks is not something to try to predict. If you’re spending from your portfolio you should talk to your advisor about ensuring that you have a combination of income providing securities and/or fixed income sufficient to meet a few years of cash flow needs. This will allow you to weather any short-term drop in the market.
One common investor flaw is taking something in the present and extrapolating it into the future, believing that what you see today is what you’ll see tomorrow. But that can’t be so or markets would only go in one direction. Time after time research and experience have shown that investors cannot accurately predict the future with enough consistency to beat the market by timing in and out. Keeping a strategic asset allocation in the face of uncertainty may seem like doing nothing, but we believe it is the right thing to do, despite being psychologically difficult.
Harli L. Palme, CFA, CFP®