08 Nov 2002 Peaceful Revolt

Every two years we undergo a peaceful revolution in this country known as the mid-term elections, where one third of the Senate and all of the House of Representatives are elected or re-elected.  If you are a Democrat, the last thing you want to read is more talk about the election, but please bear me out.  There are some vital observations that may have been lost so far in the emotion and hype. 

The House, known as the popular body of government, is designed, through two-year elections, to quickly reflect the public mood.  Members of the Senate, the more reflective body, hold terms for six years.

Now you have heard many times by now how rare it is for a sitting President to gain seats in the House and the Senate.  There is usually a backlash caused by some or all of the new President’s policies.  The electorate generally expresses its ill mood by giving the opposing party a majority in one or both houses of Congress.  It last occurred in 1994, two years into Bill Clinton’s Administration.  There was a strong backlash in this country caused by the President’s and Hillary’s spearheading a national health care initiative.  You will recall that the stock market was terrible in 1994 as the economic recovery following the 1990-91 recession was plodding along and Clinton’s popularity had fallen significantly.

What carried the elections of 1994 was Newt Gringrich’s “Contract with America.”  The Republicans won a decisive majority of both the House and the Senate with a pro-business, pro-taxpayer agenda.  President Clinton heard the public outcry registered by voters and changed his anti-business policies to a more accommodating stance.  As the S&P 500 chart below shows, investors began to believe, after some retesting of lows, that the newly elected Republican House and Senate could work effectively with the President to stimulate business investment.

S&P 500 After Vote of 1994

Now, for the first time in fifty years we have a Republican Congress and White House.  Without analyzing the reasons for the sea change, let’s simply note that President Bush has an apparent mandate to proceed with his fiscal policy.  Some of his initiatives include or might include:

• Making tax reductions permanent – the only way they can have impact on business planning and job creation.
• Eliminating the double taxation of dividends – numerous companies would consider paying out their significant cash reserves to shareholders, improving returns.
• Capital gains tax cut – frees up unproductive capital.
• Permanent elimination of the death tax – a real boost to small businesses.
• Tax simplification – flat tax or sales tax would greatly improve economic productivity as corporations and individuals are freed from the millions of hours required to compute tax liability, as well as improved compliance and collections.
• Business tax credits to spur investment.
• Reform of corporate liability laws – an example – several major industries are held hostage by asbestos litigation.
• Reform of outdated telecommunications laws – build-out of the Internet as well as the very survival of the regional Bells is in the balance.

These changes will take months or years to be realized, but the market may begin anticipating their positive effects soon.  In the meantime, the Federal Reserve cut rates by the full one half percent we expected.  The significant cut, in our view, is designed to do several things.  The Fed’s primary reason for cutting again after almost a year is to sustain the consumer that is so important to this fragile economic recovery, essentially buying time for the business recovery.  Businesses are also reorganizing their capital structures to utilize the low-cost short-term rates.  A cut supports them as they re-deploy capital.  And finally, the Fed made the significant cut to provide additional liquidity given “heightened geopolitical risks.”

The Business recovery will begin as excess capacity is better employed.  We are seeing signs in a number of places that point to economic improvement.  Tom Galvin of Credit Suisse First Boston points out that commercial paper issuance, which tends to parallel business investment, has risen 5% since July lows (or roughly 25% on an annualized basis) after contracting for two years.  We are seeing improved spending on advertising in radio, television, and print media.  They expect it to carry through following political spending.  Temporary staffing agencies are seeing significant and sustained improvement in their businesses.

While pessimism continues, consumer spending continues to positively surprise.  The positive effects of recent mortgage re-financings have yet to hit the economy.  The war in Iraq, the West coast dock problems, and all the other bad news has many predicting the worst Christmas since 1990.  Indeed, many retail stocks already reflect this possibility.  But let’s not forget how wrong the experts have been regarding the consumer so far.  Job losses do continue, but the rate is declining.  Back in 1994, our Fed was convinced that unemployment below 6% was inflationary.  As of October, unemployment remained well below that at 5.7%.

The recovery is expected to be slow and likely bumpy.  The threat of war with Iraq will keep the brakes on growth until there is some concrete resolution of the conflict.  But all the other ‘stars’ are aligning themselves for recovery, economic and market.  We are excited about the improving investment climate and think it is sustainable.

We wish you a happy Veterans Day and proudly salute those veterans among us, and those in our hearts, who risked or gave their lives for this great country.  It is no coincidence that Veterans Day falls in the shadow of Election Day.  We must always remember the dear price paid by so many Americans before us and among us for the freedom we now enjoy and for our right to peacefully ‘revolt’ every two years.