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Political Interest

Aug. 16, 2010 2:31 PM ET
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Time was when either nurturing prospects in the direction of a signed contract or pouring over results with existing clients (hoping to keep the signed contract in force) Investment Advisors would relegate "Politics" to the same conversational bin reserved for "Religion" and "Sex". These comprised an unholy triumvirate among which the restrained and the wise refused to tread, always with instinctively good and sound reasoning.

The latter two remain in the spoken wilderness, but Politics is no longer prudently ignored. This is so because time also was when politics did not intrude as extensively as it does today, upon virtually all aspects of life. What follows are numerical approximations --- the underlying data are so vast in scale that no two observers among any 5,000 or so would arrive at identical percentage calculations in any event.

A brief history. The latter half of the 1940's marked the first time in U.S. history in which large standing armed forces and a focus on military preparedness stamped our National life following the cessation of former hostilities. All treaties had been signed and ratified during Spring-Summer of '45, but everyone paying attention knew that the Nation was not at "peace" in the genuine sense of that term. Moscow was by no means seen as the only centerfold of the new threats, but it was as good a place to start as any. In any event, from that time until only recent years did aggregate Federal spending more or less come and go in a range of 18-20% of Gross National Output, or as it is termed today, GDP. Both Party and electoral politics were as they are properly intended --- rough and tumble affairs, but all the arguments and disagreements came down essentially at the margin. Put another way, that 18-20% range --- sliding up and down largely in response to nothing more than the business cycle, itself a function largely of the inventory cycle --- is best thought of as a consensus.

Beginning sometime around 3 years ago that consensus melted away. Common purpose and shared objectives among Democrats and Republicans rarely surface, members of the opposing camps linked only by some human genetic composition. Meanwhile aggregate Federal outlays have scooted to a range of 26-28% of GDP, the latter now measured in excess of $14 trillion annual rate. We are talking real money here, and it becomes increasingly challenging to identify an aspect of life in which either some Federal Agency --- or by dint of Federal mandate its first cousin at the State level --- does not stride along with us. It seems to me that an attitude tipping point has been reached among the voting age population, underscoring various "approval" ratings tumbling down in recent months.

The implications for investors in U.S. capital markets? Most credible accounts see the Republicans gaining a majority of seats in the House, and at a minimum tightening up the arithmetic in the Senate. Many recall a similar overall pattern from the mid-term polling in 1994 and how, in that immediate aftermath the bond market staged a powerful price rally. Yields on then outstanding 10 Year area Treasury Notes schussed from roughly 6 to roughly 4%, imparting a huge capital gain in the process. It was not long into 1995 that common stock prices followed suit, and with occasional exceptions kept on chugging right through the Spring 2000 tops. This time around I believe we should expect the opposite in the bond market, but at least a directional similarity with stocks. If the GOP does succeed this Fall in line with current polling estimates interest rates are most likely to rise in the aftermath, and at all points along the spectrum, overnight straight out to 30-40 years. Why? The perception will be that today's combination of harmful Federal policies will (at a minimum) not be extended or (at an optimistic maximum) gradually be rolled back. Those lethargic GDP numbers marking daily news releases of recent weeks will perk up, bringing with them interest rates to mature and grown up levels. No need to expect anything cataclysmic in this scenario --- money market rates moving toward 2-2.50, intermediate and long dated Treasury yields to either side of 4%. Such levels would support handsome P/E ratios on equities, in the new environment buttressed by some growth in the "E" beneath the "P". There exists no good reason for us to assume we have witnessed this Century's final bull market in U.S. common stock prices.

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