From the September 2008 issue of Boomer Market Advisor • Subscribe!

The election's effect on the equity market

As the country prepares to elect its 44th president, the tax policies this individual selects will have a significant affect on the stock market and overall economic growth. Broadly speaking, the stock market represents the intersection of expected future corporate cash flows and the return investors require on their investments, or the equity discount rate.

We can think of these factors as "numerator" and "denominator" issues. Numerator issues relate to profits and cash flows, while denominator issues, such as tax rates, inflation, and risk relate to the equity discount rate. Because profits and cash flows are commonly measured, the financial press focuses almost exclusively on the numerator side of the market. Equity discount rates, in contrast, receive very little media attention, but are equally important to cash flows in determining stock market values. At any point in time, the equity discount rate for a particular company or the market in general consists of four components: A base real rate of return, inflation, taxes and risks.

In order to focus on how tax policies affect the equity discount rate, let's assume that equity investors want a 4 percent base real rate of return and the required compensation for inflation and risk is expected to be 0 percent. Let's evaluate how the tax policies for the two competing presidential candidates affect the stock market. John McCain advocates maintaining a 15 percent tax rate on capital gains and dividends, while Barack Obama first advocated moving the rate to 39 percent, and then offered a lower rate of 28 percent. A higher rate of, say, 35 percent will increase the equity discount rate by more than 30 percent. To put this into perspective, use a hypothetical company that is expected to generate $100 a year of cash flow into perpetuity. Under these circumstances, the values of this company under the policies of McCain and Obama are $2,127 and $1,613, respectively.

As taxes on investments, investors require higher overall rates of return and they'll pay less for any given investment. By extension, the tax rate on investment returns increases, the value of those investments in the economy decreases. In the context of the stock market, moving from lower investment tax rates to higher investment tax rates will lead to a drop in market values, all other things equal.

Unfortunately, this is not the end of the story. As tax rates go up and increase the equity cost of capital, by definition there will be fewer investment opportunities that meet this new, higher required investment rate. As a result, companies, and entrepreneurs will find fewer acceptable investment opportunities. This results in fewer investments throughout the economy and subsequently slower growth.

So while this may sound good in theory, is there any proof that the markets react to such tax information?
During the Bush-Kerry election in 2004, each candidate staked out opposite positions on capital gains taxes. President Bush argued that the current 15 percent rate should be maintained and made permanent, while Senator Kerry advocated raising them on the top 2 percent of wage earners. Flawed polling data leaked to the press indicated that Kerry would win Florida and the entire election. Prior to the false news, the Dow increased as much as 125 points, or about 1.2 percent during the day. After the leak, the market proceeded to fall 150 points (about 1.5 percent) from its peak. In other words, the prospect of higher taxes immediately motivated investors to sell assets.

Rafael Resendes is managing director and portfolio manager for Toreador Research and Trading.

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