The Election, Gridlock & Where I’m Investing Now

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
November 14, 2006

IN THIS ISSUE:

1. Election Postscript: Democrats Ran The Table

2. Who Will Control The Dems – Hillary Or Pelosi?

3. Will It Be “Gridlock” For The Next Two Years?

4. Is Gridlock Good For The Markets, Or Not?

5. Where I’m Investing My Own Money Now

6. Potomac Fund Management Revisited

Introduction

This week’s E-Letter will cover several issues. First, many people are asking me what to expect on the political front in the wake of the midterm elections, so I’ll give you my bottom-line analysis on that – you may be surprised. Second, people are also asking me why the stock market set new highs going into the election which favored Democrats, and I will explain that too - (hint: gridlock.) Third, people want to know how and where to invest their money in the wake of the election results. I will give you my latest advice on that as well. I will also tell you the one investment I’m doubling my investment in now in the pages that follow.

As for number one, the election came and went, and the Democrats ran the table, picking up 30 House seats, six Senate seats and majority control of both houses of Congress. Conservatives will have to live with the Democrats in control of the Congress for at least two more years and perhaps a lot longer, especially if Hillary Clinton wins the White House in 2008, which is a real possibility.

Now that the Democrats are in control of Congress, it will be interesting to see which wing of the Democrat Party is successful in controlling the agenda for the next two years. You have the Hillary Clinton/Rahm Emanuel wing of the Democrat Party, which is ALL about staying in the center and positioning for the 2008 presidential election. And then you have the Nancy Pelosi/Harry Reed, et al wing of left-wingers that want to advance a very liberal agenda. It will be very interesting to see which group wins this battle.

As for number two, the stock markets rallied strongly even in the face of polls which indicated that the Democrats would win control of one or both Houses of Congress. Why did that happen? I will tell you that it’s one part the good economy, one part no more Fed rate hikes, and one part (maybe the most important part) gridlock in Washington for two more years.

And third, where to invest for the next two years? With the Democrats in control of Congress, it remains to be seen what changes in government policy (taxes, regulation, et al) we could see over the next two years or longer. But I think it is safe to assume that market volatility – up and down will likely only increase even more over the next few years. So, in addition to my analysis on where to invest, I will also tell you the one investment I am doubling up on now.

Lastly, I am still overwhelmed by the huge outpouring of very positive comments we have received from readers since I offered the free “All They’ll Need To Know” booklet for planning for one’s eventual death (copies are still available). Praise for this weekly E-Letter has been astonishing in the last 2-3 weeks. Thank you so much!

Now What In The Wake Of The Election?

To my many conservative readers, we should not be surprised that the Republicans lost big-time in the midterm election. Republican congressmen and women, and even President Bush, failed to advance conservative values and issues in recent years. They expanded the size of government and proved they can spend with the best of the Democrats, or even better. Then there were the scandals. And then there was the war in Iraq which has gone badly. Republicans lost for all these reasons and credibility in general.

Now we have the Democrats in control of both the House and the Senate. If you have paid much attention at all since the election, you have seen the “love-fest” that went on last week between President Bush and the new Democrat leaders in the House and Senate. This is normal. Everyone talks about bipartisanship and getting along just after elections, especially when there is a major power shift and divided government. But that will change soon enough.

As noted above, there are two distinct wings of the Democratic Party. There is what I will call the Hillary Clinton/Rahm Emanuel wing of the party. These are the Clinton Democrats who are committed to see Hillary become the first female president of the United States in 2008. Make no mistake, these are very liberal Democrats, but they have moved to the political center because they know the American people will not elect a very liberal person to the highest office of the land.

Then there is what I will call the Nancy Pelosi/Harry Reed, et al wing of left-wingers that want to advance a very liberal agenda over the next two years. This group includes numerous prominent Senators and Representatives. Many in this group favor pulling our troops out of Iraq as soon as possible, rolling back Bush’s tax cuts and increasing taxes on the rich, and even impeachment investigations on the war in Iraq.

The Clinton/Emanuel wing of the Party wants the Pelosi/Reed wing to behave themselves for the next two years so that Hillary can be elected president in 2008. They don’t want the Pelosi/Reed wing to go nuts and turn the electorate against the Democrats in 2008. So it will be very interesting to see which wing of the Party gains control.

Along this line, an interesting development occurred over the weekend. It is widely assumed that Nancy Pelosi will be elected Speaker of the House, and she is already acting as if that is a done deal. Then there is the election of the House Majority Leader. Over the weekend, it was announced that Pelosi is backing Jack Murtha for majority leader, and that she has passed over Rahm Emanuel for the #2 spot in the House.

Jack Murtha is one of the earliest “cut-and-run” in Iraq advocates, having called last year for our troops in Iraq to be immediately redeployed to Okinawa. Murtha has slandered our troops on more than one occasion and last year accused the Marines of murder “in cold blood” of innocent Iraqi citizens and charged there was a military cover-up of the matter. Murtha has a tattered past of alleged corruption as you can read in the Washington Times editorial below.

On the surface, the selection of Jack Murtha for House Majority Leader would suggest that the Pelosi wing has already gained the upper hand over the Hillary wing. If so, that is a sign that we may be seeing some of the nastiest politics in years between now and 2008, including impeachment investigations over the war in Iraq.

While Pelosi stated last week that impeachment investigations are not on the table, she may not have the power to stop them (assuming she would even try) if certain members of the House and Senate want to proceed. Those decisions will likely lie with Democrats Carl Levin who will likely be the new chairman of the Senate Armed Services Committee, and John Conyers who will likely be the new chairman of the House Judiciary Committee. It would likely be Levin who would initiate impeachment investigations next year, if they are to come.

Interestingly, Hillary Clinton is also a member of the Senate Armed Services Committee. She does not want to see the Democratic Party become mired in an impeachment effort that would almost certainly drag on into the 2008 presidential election. So it will be interesting to see if she can muzzle Levin and Conyers. By the way, over the weekend Senator Levin called for the removal of US troops from Iraq to begin within the next 4-6 months.

I could go on and on with examples of what to watch for in the next year, but I think you get the picture. If Hillary gets her way, the Democrats will behave themselves, pass some legislation such as raising the minimum wage and an immigration bill, and try to convince the American people that more Democrats should be elected in 2008. If, on the other hand, the Pelosi wing is the dominant force, the liberals may not be able to control themselves and could cut off funding for the military in Iraq, raise taxes and pursue impeachment, among others.

Markets Rally On Prospects For “Gridlock”

The stock markets have rallied strongly over the last several months even as the election forecasts shifted in favor of the Democrats. The Dow Jones Industrial Average managed to soar to a new all-time high above 12,000 and remains there as this is written. As noted in the Introduction, the bull market in equities is being driven by several factors including the economy and the growing perception that the Fed is done raising interest rates and will likely cut rates next year. Even the latest disappointing 3Q GDP report (up only 1.6%) had little negative effect on the markets.

There is also a growing perception that the strong rally in equities over the last several months has been helped along by the anticipation of “gridlock” in Washington. With Congress in the hands of the Democrats and Bush in the White House, many believe this means that nothing much of significance will happen for the next two years. There have been similar periods of gridlock in the past when the equity markets have performed quite well. Maybe this partly explains the markets’ strength over the last several months.

In my October 24 E-Letter, I suggested that the stock markets could be in for a potentially significant downward correction if the Democrats won a big victory in the election. Obviously, that suggestion has not come to pass, at least so far. Given that my suggestion of a correction has not happened so far, let’s see what our friends at The Bank Credit Analyst are thinking about the stock and bond markets since the election:

The equity market stumbled a bit after the election, as investors fretted that the new Congress might become hostile towards the corporate sector, particularly the health care and pharma sectors. While there are risks that select areas might lose as a result of the modest shifts underway in Washington (and the press will play up the potentially negative outcomes), we doubt that changes will be sufficient to derail the overall bull market. In addition, the bond market has been calm, which is positive for our call for a re-rating in equity valuations. Stocks had been modestly overextended and a temporary setback could occur, but liquidity trends will stay bullish.

We noted in the August 11th Bulletin that the Hong Kong stock market seemed to be leading the U.S. higher. The former has continued to advance, which bodes well for the S&P 500 index. While some investors are still worried that further monetary tightening looms, the main near-run threat to stocks is from the trend in earnings. Even here, conditions are not particularly bearish: profit growth should decelerate, but a margin crunch and contraction in profits are not likely. Demand is softening, but the drop in energy prices, lower borrowing costs and a soggy dollar are supportive for margins.

Earnings revisions have weakened in recent months, but this has not derailed the market, only made it easier to beat expectations. The gap between actual and estimated earnings growth has been improving, which has helped the market sustain its advance. Obviously, anything that causes either profits to contract (a hard economic landing) or bond yields to rise would warrant a cautious investment stance. However, we remain optimistic and are maintaining an above-average weighting in stocks.

The changing of the guard in Congress did not unnerve bond investors. Worries that the Democrats might revert to their big-spending days have been a losing bet since President Clinton’s era, and we doubt major initiatives that would undermine Treasurys will occur in 2007. One could even argue that the electoral change might be for the better, in that government spending has already boomed this decade. According to our Washington editor, the next Congress should be more fiscally responsible on the margin, because voters elected a lot of fiscally conservative people. Gridlock seems to be the safest bet for the next two years.... [Emphasis mine, GDH.]

To summarize, the editors at BCA continue to believe that the economy will remain in a mild slowdown for another quarter or two, but they do not believe we will slip into a recession. They believe the Fed is done raising interest rates and predict that the FOMC will cut rates several times next year in order to stimulate the economy. While the editors do see a slowdown in corporate earnings next year, they continue to believe that stocks will move higher over the next year, but not without some potentially scary corrections along the way.

Another Gridlock Viewpoint

As is common in the political and financial world, there is an alternative opinion in regard to whether political gridlock will be beneficial to the stock markets in the next two years. As noted above, conventional wisdom seems to think that gridlock will be good for the equity markets. We can look back as recently as the Clinton Administration after 1994 to see the positive stock market effects of having a White House controlled by one political party and Congress controlled by the other. That period of gridlock led to the greatest stock bull market in history.

However, there were several other very significant factors at work during the 90s that also had a big part to play in the bull market, other than divided government and gridlock. Not the least of these was the “peace dividend” resulting from the fall of the USSR. As the world’s only remaining superpower in pre-9/11 America, even many Republicans felt comfortable in reducing the size of the military. This, in turn, resulted in lower governmental outlays for defense, and helped to contribute to a budget surplus, which helped fuel the equity markets.

Another factor contributing to the Clinton-era prosperity was the explosion in technological innovation and its effect on productivity. You may recall that even the great Alan Greenspan couldn’t figure out how we could have an economy expanding at the rate it was without even a hint of inflation. Sure, the technology sector eventually became a market bubble that popped, but this was hardly the effect of political gridlock.

Many articles I have read in regard to the effects of gridlock discuss how investors have short memories, and that the recent memories of the 1990s gridlock and simultaneous market boom are all that is propping up the stock market at the moment. I don’t believe that. Yet as gridlock “believers” continue to pour money into the market, one recent study says they may be setting themselves up for a fall.

The study, entitled “Gridlock’s Gone, Now What?” was published in the September/October issue of the Financial Analysts Journal, an industry publication aimed at investment professionals known as Chartered Financial Analysts (CFAs). The study’s authors, Robert Johnson, CFA, Ph.D and Scott B. Beyer, CFA and Gerald R. Jensen, CFA, analyzed stock market data from 1949 through 2004 to determine the effects, if any, of political gridlock.

Their work concluded that the idea that political gridlock favors stock returns is a myth, but that gridlock may have a positive effect on fixed income returns. Specifically, their study reached the following conclusions:

Equity markets have historically done better when the same political party controls both Congress and the White House. Stock returns were both higher and less volatile during periods of political harmony than during gridlock;
Gridlock has historically favored fixed income securities such as bonds, possibly the result of lower governmental spending and its effects on inflation and deficits; and
Large-cap stocks tend to do better during periods of gridlock than small-cap stocks, indicating that the small-firm premium may be absent during gridlock.

There are other studies which support the idea that gridlock in Washington is good for the equity markets. As usual, it comes down to which time periods one chooses to consider. There are periods when gridlock was very positive for stocks, and there are periods when the same party ruled the White House and Congress, and equities did very well.

So who’s right, the pro-gridlock or anti-gridlock forces? Unfortunately, it’s impossible to predict. And I don’t believe that gridlock, or no gridlock, is the main factor that is driving equity prices higher. Gridlock, if that is what we’re going to get (and I’m not sure it is), is only one factor.

At the end of the day, I tend to believe that BCA is going to be correct in their assumption that the stock markets will continue to trend up over the next year or so, but I also continue to expect that volatility will continue to increase – both on the upside and the downside.

Investment Implications

Over the years, I have often been asked why I write about politics in an investment e-letter. My answer has always been that what goes on in the political world has the potential to affect your investments – sometimes in a major way. I have always viewed my role as one of helping investors find the most suitable investments for not only their own personal financial situation, but also in light of what’s going on in the investment world, and politics is part of that world.

It is my strong opinion that there is no such thing as a “one-size-fits-all” investment, though the financial industry seems to try to promote various products as just that. If I can help investors sort through the maze of investment alternatives and select a blend of programs that will help meet their financial goals with less risk, then I have done my job.

So, how should you position your investments when it’s not even clear whether political gridlock may or may not be good for the markets, or whether we will actually see gridlock just ahead? It may surprise you, but my opinion about how to invest for the next couple of years hasn’t really changed, even in light of the latest Democratic takeover of Congress.

My advice remains the same, that you consider investment programs that are “actively managed” and have the ability to move to cash or hedged positions during extended market downturns.

While it’s a matter of debate as to whether the markets like Republicans more than Democrats, it’s certain that the markets hate uncertainty, and there’s no shortage of that in the world today. From crude oil prices to Iran’s and North Korea’s nuclear threats, to the whole matter of terrorism, there are plenty of factors that could affect the markets, both positively and negatively.

During periods of uncertainty, I think it is imperative to have at least part of your money managed in such a way that it can hedge or go to cash if the market experiences a major correction or bear phase. During periods of gridlock and global instability like we have now, I think the percentage you commit to these active management strategies should be even greater.

The overall goal of these active management strategies is to reduce losses during the bad times and give you a smoother ride on your way to your investment goals. As I noted above, one recent study shows that periods of political gridlock are usually accompanied by greater market volatility. It’s this market volatility that often causes investors to make emotional decisions and pull out of their buy-and-hold investments when losses occur.

With an active management strategy, you have the comfort of knowing you have professional money managers monitoring the markets on a daily basis, and who have the flexibility to move to a hedged or cash position in extended downward markets in an attempt to preserve principal. Carefully selected active management strategies offer the potential for impressive risk-adjusted returns, with lower drawdowns during down market phases. (Of course, past results are not necessarily indicative of future results.)

I believe in the concept of active management so strongly that my firm specializes in finding and analyzing such programs, and then introducing them to my clients. I also invest my own money alongside that of my clients in all of the programs I recommend. I also recommend that clients diversify their portfolios with multiple active management strategies and managers, just as I do. Likewise, I recommend my clients re-evaluate all of their portfolio holdings at least annually and make changes in their portfolios accordingly.

I recently completed my own review of my personal portfolio, and I am making a change that may be of particular interest to many of you who read this weekly E-Letter. I am now in the process of more than doubling my investment account with Potomac Fund Management as we speak, due to the economic and market uncertainties that I see ahead for the next year or longer.

Revisiting Potomac Fund Management

In my October 24, 2006 E-Letter, I discussed how Potomac Fund Management is one of my favorite money managers, and has been a staple in my own portfolio for a number of years. What I like most about Potomac’s Guardian Program is that it embodies the very risk management techniques that I think are so critical during times of global uncertainty.

I also like the fact that Potomac’s Guardian Program has experienced various market environments – good, bad and sideways. It began in the mid-1990s during the latter phase of the record bull market, but also endured the bear market of 2000 – 2002 and the sideways markets of 2004 and 2005. How this investment program performed well during these very different market environments is an important part of why I recommend Potomac so highly.

As I noted in the October 24 E-Letter, Potomac has decided to increase their minimum investment from $25,000 to $50,000 at the first of the year. This is a common practice for money managers who have a good track record and now manage a significant amount of assets. At the risk of sounding like a broken record, I encourage you to check out Potomac’s Guardian Program while you can still invest as little as $25,000.

Click on this online link to access additional detailed information about this actively managed investment program, including performance numbers that have been updated through the end of October. As I noted above, I am significantly increasing my own personal investment in the Potomac Guardian Program, and I think it also merits your serious consideration if it is suitable for your investment goals and risk tolerance.

If, after reviewing the online information, you have questions or would like to learn more about the Potomac Guardian Program, please feel free to give one of our Investment Consultants a call at 800-348-3601, or contact us using our online information request form.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

The real Jack Murtha.
http://www.washtimes.com/op-ed/20060620-083859-8753r.htm

Republicans lost but conservatism didn't.
http://www.humanevents.com/winningthefuture.php?id=18032

Hillary's Dilemma
http://www.usnews.com/usnews/news/articles/061112/20hillary.htm