The Payoff In November

By Daniel Kadlec

From drugs to financials, the stock market is trying to anticipate who will win the White House this fall. Sorting it all out is a TIME panel moderated by senior writer DANIEL KADLEC and including Richard Bernstein, chief U.S. strategist at Merrill Lynch, Gregory Valliere, chief political strategist at Schwab Soundview Capital Markets, and Thomas Gallagher, chief political analyst at ISI Group.

TIME: Do Presidents and politics move markets in ways we can anticipate?

THOMAS GALLAGHER: Sure. But unlike with economic or industry news, markets tend to react to politics--not discount them ahead of time. That creates opportunities if you can anticipate political trends. In the '92 election, we had a Clinton stock index, and for a 10-week period starting in mid-September, it outperformed the S&P 500 by 10 percentage points. But most of the move came after the election. Very little had been anticipated.

GREGORY VALLIERE: In normal times investors look at things like profits and interest rates. But these are different times. There are two new factors playing a huge role. One is the terrorism premium. Is it 25% of the price of oil? Nobody can quantify, but it's there. The second one is the election. There, I would not look at it in sweeping terms. The main issue is stock sectors, and there could be some pure plays in things like health care and other sectors depending on who wins.

TIME: We'll get to that. First, a word on the Fed chief, Alan Greenspan, whose term expires under our next President.

VALLIERE: Greenspan day in and day out is more important to the economy than the President. But whether it's Kerry or Bush, whoever chooses Greenspan's replacement in '06 will choose a centrist.

TIME: Like Bob Rubin?

GALLAGHER: If Kerry wins, no reason to think otherwise. At the convention Rubin was sitting next to Teresa Heinz [Kerry].

TIME: Like Greenspan sat next to Hillary Clinton 11 years ago.

VALLIERE: Yes, at the State of the Union address. If Bush is re-elected, I'm sure [Harvard professor] Marty Feldstein is on the short list. Feldstein is a fairly moderate Republican.

GALLAGHER: The transition process will be turbulent. Feldstein had a whole different approach to deflation risk. He thought there should have been a much more aggressive fiscal approach, which would have had the Fed chairman aggressively endorsing tax cuts. He's also a big advocate of Social Security reform.

TIME: Does choosing the next Fed chief shape up as the biggest decision the next President will make for investors?

RICHARD BERNSTEIN: Whoever is President, they'll end up raising taxes because the deficit is a problem. That may be a bigger issue than the Fed chairman in '05.

VALLIERE: I'm a deficit dove. The deficit is coming down, and the correlation between big deficits and high interest rates is shaky at best anyway. So I don't think there would be a tax increase with Bush.

BERNSTEIN: Well, I'm a deficit hawk. I believe we're in a generally deflationary environment and that government should have as clean a balance sheet as possible. As we go through '05, we are going to need to correct those deficits.

TIME: What kind of tax increase might we see under Bush, Rich?

BERNSTEIN: He's not saying anything, so who knows? If he does nothing, it will effectively be a tax increase because certain tax cuts will expire. So he doesn't have to be aggressive; all he has to do is sit back.

VALLIERE: The big one is December 31, 2008. That's when the dividend and capital-gains rates of 15% go back up. The estate-tax cut expires in 2010.

TIME: Is there any practical advice for investors while taxes are front and center?

BERNSTEIN: Two things: There's a feeling that when taxes are raised, it's bad for the market. That's not necessarily true. Clinton raised taxes, and we had a bull market. People should invest on a pretax basis. The after-tax effect is icing on the cake.

VALLIERE: Stocks that have good dividends are going to be fine for the next couple of years. If Bush wins, he's going to try to make the 15% rate permanent. If Kerry wins, his efforts to abolish the 15% rate would run into a brick wall.

TIME: Stocks tend to do best under Democrats, which surprises people.

BERNSTEIN: Yes. We looked at 1943 to the present and tested different periods. The results were consistent. Under Democrats, the optimal asset allocation is two-thirds stocks, one-third bonds. Under Republicans, it is 64% bonds, 36% equities. Consumer stocks perform better under Republicans, and industrials tend to perform better under Democrats. The one that really shocked us: energy tends to perform better under Democrats.

TIME: Wow. With Bush's oil ties?

BERNSTEIN: Maybe it's that Democrats can actually do things to help the energy sector, whereas Republicans can't because it would seem self-serving.

TIME: It certainly makes you think twice about investing on stereotypes.

VALLIERE: To that point, people say Kerry would be good for bonds, based on his wanting to cut the deficit. I'm unpersuaded. In order to be good for the bond market, he would have to undo the Bush tax cuts. That's not going to happen.

GALLAGHER: In the short run, Bush is good for stocks, and, yes, Kerry is good for bonds--stocks because of the dividend-tax issue and bonds for a couple reasons. One is that Clinton's policies produced budget surpluses and Kerry sees things much the same way. Meanwhile, Dick Cheney is saying that deficits don't matter. Then you have the gridlock argument. The bond market would assume Kerry's spending initiatives would get frustrated. So you lower the deficit that way. And Bush does talk about Social Security reform. Under typical proposals, that would add about a hundred million dollars a year to the deficit for the next 10 years.

TIME: But it sure would help the financial-services industry.

GALLAGHER: Financial services would benefit more from an expanded IRA, which has a greater chance than Social Security reform. Reform wouldn't funnel money into private mutual funds but to companies that index the market. The tax-free savings account is a bigger deal.

VALLIERE: Even if there were Social Security reform--and I think the chances are below 50%--they will cap the fees. I talk to people in my industry who think they wouldn't make any money on it.

TIME: Heightened terror concerns this summer held back stocks. Can the market ever roar again in a code-orange world? BERNSTEIN: I don't think that's what's holding the market back. We're in a situation where it's pretty clear the Fed is going to tighten and you have slowing earnings growth. Surprise, surprise, the market is not doing all that well.

VALLIERE: Wouldn't you have to say that there's some terrorism factor? The fact that oil is at $45 a barrel.

BERNSTEIN: There's a speculation thing in oil; the hedge funds are running wild.

TIME: Well then, are the market's ills related to election uncertainty?

BERNSTEIN: Honestly, I think it's more the uncertainty of interest rates. But I'll say this: Over 70% of money managers think Bush is going to win. In theory, that's priced into the market. The biggest surprise that would move the market would be a Kerry win.

GALLAGHER: The last two times you had a Democratic challenger beating a Republican incumbent, there was a selloff in the fall, and then in '92 you had the rally starting a couple of weeks before the election, and in '76 you had the rally right after the election.

TIME: Let's talk about stock sectors, starting with the health-care industry.

VALLIERE: One big story is the drug stocks, like Pfizer and Eli Lilly. If it appears that Kerry has a decent lead sometime after mid-September, the drug stocks, which haven't had a great year anyway, could come under more pressure. Kerry could do things through regulation. If it looks like Bush is going to win, there would be a decent rally for the drug stocks. And it is my belief that hospitals, HMOs, nursing homes might do better under Kerry because the Bush budget in early '05 would give a haircut to these sectors.

BERNSTEIN: Most health-care analysts have been focused on the pressure the government will be applying. They have not studied the increased usage when drug prices come down, which at least partly offsets that. And drug companies are not cyclical. What we've seen in the last year is quite normal for a period where profits are accelerating. When the profit cycle decelerates, drug-company valuations come right back.

TIME: Let's go to defense stocks.

GALLAGHER: We have defense stocks as a long position in the Bush index but not as a short position in the Kerry index because I don't think that either would be able to cut defense spending. Bush might be a little more favorable. But I don't see defense as greatly in play.

VALLIERE: The perception is that the defense stocks could suffer under Kerry. The reality is it's unlikely Congress would agree to whack these programs.

TIME: So if defense stocks fall with a Kerry win, buy them?

VALLIERE: Probably.

BERNSTEIN: There aren't many industries that you can feel certain about 6% or 7% revenue growth for several years, which is the case with defense contractors.

TIME: What about energy?

BERNSTEIN: Energy is the long-term growth story in the United States. You have tremendous undercapacity and barriers to entry. Do you know that Indonesia, which is an OPEC country, is an importer of oil? It's not that they don't have it; they haven't invested in the infrastructure to get it out of the ground.

GALLAGHER: The Kerry environmental agenda is negative for traditional energy producers but positive for alternative energy producers.

VALLIERE: A pure play here would be coal. Kerry and his wife have a strong bias against coal in terms of regulations and emissions. But they would be good for alternatives like wind and solar. Florida Power & Light is considered the leader in developing wind power.

TIME: How about financial services?

VALLIERE: The purest plays in this election are FREDDIE MAC and FANNIE MAE. The Republicans have taken a very harsh view on their line of credit with the Treasury, whereas Kerry really likes Freddie and Fannie. If it looks like Kerry is going to win, I think Freddie and Fannie would be clear winners. Democrats feel very strongly that the government's line of credit to Fannie and Freddie is desirable, that it promotes home ownership.

GALLAGHER: If Bush wins, by the way, they are really coming after Fannie and Freddie next year. They're asserting the Treasury's authority to regulate the amount of debt that Freddie and Fannie issue. That's a power that's been in the closet. It's like a visit from the Ghost of Christmas Future. This is what your future is if you don't change. So that's a meaningful issue for Fannie and Freddie.

TIME: Any other industries to talk about?

GALLAGHER: If Bush wins and the Republicans do surprisingly well in the Senate and the Democrats feel they paid a price for their stand opposing tort reform, you could get some significant relief for companies with asbestos liabilities. Some, like maybe USG, if they go bankrupt, are $5 stocks, but if we get asbestos relief are $35 stocks.

BERNSTEIN: A lot of engineering and construction firms fall in this category.

VALLIERE: Yes. I can see a re-elected President Bush vetoing the highway bill. So I agree Kerry is more favorable for construction stocks.

TIME: Thanks, all.