For investors with election angst, an idea: Don’t worry. (But good luck with that.)

October 2, 2012

Every four years, as investors fret over the impact Election Day might have on their portfolios, every corner of the economy gets analyzed for a potential rally. Might defense stocks do better if Mitt Romney gets elected? Could health care surge under President Obama? Or will financials take off if he leaves the White House?

“I don’t know, and I don’t care,” said Jerry Verseput, a former Intel-engineer-turned-investment-manager who is pioneering a new attitude toward election outcomes: Don’t worry about them. He is launching a mutual fund that will make money based on mere volatility — wild swings in sectors such as defense, health care and financials, as opposed to a surge in prices.

“It’s great not to care,” he said.

But it isn’t always easy. With the clock ticking down on $607 billion in automatic spending cuts and tax increases come Jan. 1 — not to mention another fight over the country’s legal borrowing limit — the election’s toll on your portfolio may loom large.

But it is not as big as it seems. Academic studies are mixed on how big of a cue Wall Street takes from the party controlling Washington. Others argue that more important decisions — such as the Federal Reserve’s setting of interest rates — hold bigger sway over markets. And even when taxes are set to change on a given date, taxes should never be the main driver for an investment decision.


(Luci Gutierrez/For The Washington Post)

“I think the smart money is focusing a lot less on the election and . . . recognizing that, at the end of the day, Washington can only do so much,” said Burt White, chief investment officer at the advisory firm LPL Financial in Boston. “The emotional money is focusing more on the election.”

Butter in Bangladesh?

Still, experts are hesitant to dismiss studies of investment returns and election results as just another “butter in Bangladesh” experiment. In that study, David Leinweber, author of “Nerds on Wall Street: Math, Machines and Wired Markets,” famously discovered that when he searched a non-financial database for a data series that most closely tracked the Standard & Poor’s 500-stock index, butter production in Bangladesh took the top spot — a clever way of showing that you can sometimes correlate two completely unrelated things.

When it comes to stock returns, “the economy is the most important variable by far,” said Jeremy Siegel, a finance professor at the University of Pennsylvania’s Wharton School and author of “Stocks for the Long Run.” And because the party in power sets the agenda for the fiscal policies shaping the economy, it is reasonable to wonder how stocks fare under Democrats vs. under Republicans. In his book, Siegel estimates that the S&P 500 has on average achieved an annualized nominal return of 10.9 percent under Democratic administrations, compared with 8.6 percent under Republicans. Overall, the market returned 9.6 percent, based on data from 1888 to October 2006.

“History shows markets have done very well under Democrats,” Siegel said.

A 2003 study by academics Pedro Santa-Clara and Rossen Valkanov also noticed higher returns during Democratic administrations — a finding they dubbed “the presidential puzzle.” But the finding was challenged in a 2007 study that found differences in stock market returns under Democrats and under Republicans to be unmeaningful.

Average investors do not seem to assign it much meaning. Standing outside the Broadway ticket sales center in New York’s Times Square, ticket salesman Bob Castellano, 50, detailed to a friend how his retirement portfolio slid from about $140,000 to $70,000 during the 2008 financial crisis. But Castellano kept his portfolio in aggressive stocks. It rebounded, and once he made his money back, he switched to more conservative investments.

“So what you’re saying is that when a conservative Republican was in office, you lost almost half your portfolio,” his friend said to him. “After that a Democrat came into office, and now you made all your money back?”

“I don’t know,” Castellano said. “I don’t know what it’s associated with.”

Fed matters more

Regardless of who controls the White House, fiscal decisions do not come close to what the Fed can do to whip up stock returns. For instance, on Sept. 13, stocks surged to their highest levels since December 2007 when the Fed announced a new program to inject money into the markets by buying bonds.

“It depends much more on what the Fed does — much more on what the Fed does,” Siegel said.

Other studies support this view. Scott Beyer found that when he added additional layers to the question of who runs the White House — such as political gridlock in Congress and the Fed’s monetary policies — nothing matched the effect of “expansive” Fed policies, or those designed to inject more money into the economy.

“It just seems like there is more of these expansive monetary windows tied in to when the Democrats have been in the presidency and the market’s done better,” said Beyer, a professor of finance at the University of Wisconsin at Oshkosh.

Using the same methodology, Beyer predicts the S&P 500 could return an annualized monthly return of about 26 percent if Obama wins reelection, Congress remains divided and the Fed keeps pursuing expansionary policies. That drops to about 15 percent under a Romney win, not adjusting for inflation.

“I would never invest on it,” Beyer said, “but it is interesting.”

‘Taxmageddon’

The 2012 election is all the more interesting for investors because it comes less than two months before a wave of automatic spending cuts and tax increases is set to occur. The cuts, agreed to in 2011’s budget deal, would on Jan. 1 slice 9.4 percent off defense funding, 2 percent off Medicare and 8.2 percent off other domestic spending programs.

Congress’s extension of the George W. Bush-era tax cuts is set to expire on the same day. That means the long-term capital gains tax would go from 15 percent to 20 percent. The top rate for taxes on dividends would revert from 15 percent to 39.6 percent. And the normal income tax brackets would move back up to pre-2001 levels, with a top rate of 39.6 percent instead of 35 percent.

And that’s just the beginning.

There’s also the rollback of the estate tax exemption, from $5 million to $1 million; the expiration of the 2 percent reduction in the payroll tax; and a new 3.8 percent tax on investment income imposed by the health-care overhaul law. Nor has Congress yet passed an annual increase in the exemption for the alternative minimum tax, meaning the tax could hit 34 million taxpayers next year, the Congressional Research Service estimates.

“It’s ‘taxmageddon,’ ” said John E. Sestina, who runs an Ohio-based financial advisory firm with $500 million in assets under management. “What is so startling to me is how the average person is unaware of all the additional burden that is coming.”

Experts warn that investors should not make drastic changes to their portfolios solely because of the potential tax hikes.

“The old adage is you can’t make investment decisions based on taxes,” said Mark G. Spinelli, a New Jersey tax accountant and financial planner. “You have to make decisions based on the reasons that surround the [stock].”

Still, with so many changes on the way, taxes are “one set of news items that I would say investors should stay attuned to,” said Christine Benz, director of personal finance at Morningstar in Chicago. “If taxes do go up, then you might want to make some changes before the end of 2012.”

Sestina, for example, is planning to take gains from stocks he has bought for clients by selling them before Jan. 1. That way, they can pay a 15 percent capital gains tax now, buy them back at a later date and pay the potentially higher 20 percent rate only on the future gains.

This “harvesting” of gains is a particularly good idea if an investor is sitting on a huge capital gain from a run-up in a hot stock such as Apple, said James Holtzman, adviser with Legend Financial Advisors in Pittsburgh.

Holtzman points to the tech bubble of the late 1990s as a case in point. Many of his clients saw a huge run-up in the value of their tech holdings, such as Sun Microsystems. But with capital gains taxes even higher than what they are today, many of them refused to sell, because they did not want to take the hit.

“It did not end pretty for them,” Holtzman said. They lost 80 percent or more of the value of their holdings when the bubble burst in 2001.

‘Grand Canyon’

The other danger to investors from Congress’s Jan. 1 deadline is the impact of the spending cuts on the economic recovery — and market returns.

If the full spending cuts and tax hikes take effect, the result would “probably be considered a recession,” the nonpartisan Congressional Budget Office warned in August. Unemployment would rise to 9.1 percent and economic growth would shrink 0.5 percent by the end of 2013, the CBO predicted.

The CBO’s estimated $607 billion price tag on the spending cuts and tax hikes has earned them the nickname “the fiscal cliff” because of their severity. But some economists think even that’s being too kind.

“Somehow, the word ‘cliff’ is too mild a word,” said Ken Mayland, an economist with ClearView Economics in Pepper Pike, Ohio. “It’s more like the Grand Canyon, because the numbers . . . are such that if it fully went into effect . . . it might make the 2007-to-2009 recession look like a little sprinkle.”

The full effect of the tax increases could make some assets more valuable. Municipal bonds, for example, could rally because their income is exempt from federal — and often state — taxes, said Peter Hayes, head of the municipal bonds group at BlackRock in Princeton, N.J. If taxes rise, municipal investors could keep more of what they earn relative to other assets, Hayes said.

For now, though, consensus is that Congress will avoid diving into the canyon. The latest Blue Chip Economic Indicators survey of economic forecasters found that 34 of 44 economists assume the fiscal cliff will be “largely avoided” by congressional postponement of most of the scheduled tax increases and spending reductions.

“It all comes down to how firm the lines in the sand are and what the prospects for a compromise are,” said Joseph Rosenberg, research associate at the nonpartisan Tax Policy Center.

Willingness to compromise, in turn, depends on the election.

“If Obama does not get reelected, then Republicans are going to want to wait until January when Romney takes over the White House,” said Julius W. Hobson, a lobbyist for Polsinelli Shughart in the District. That means the fiscal cliff’s effects may have to be fixed retroactively, and the markets will get nervous. “For investors, there will be that moment of panic when they don’t meet deadline,” Hobson said.

But if voters keep the status quo in Washington — Obama in the White House, Republicans in control of the House and Democrats in control of the Senate — then “there will have to be compromises,” maybe as early as Congress’s lame-duck session starting Nov. 13, Hobson said.

“Will they get around to fixing some of these issues?” Hobson asked. “The answer is yes. The question is when.”

Counting on volatility

For now, though, many investors, big and small, aren’t taking a punt on when Washington will get its act together.

In California, Verseput, the former Intel engineer, is busy launching his volatility-based fund, the VFM Steadfast Fund, with about $20 million of his clients’ money — they are mostly former Intel engineers. The plan is to buy stocks and offsetting options contracts, such as protective puts, to limit potential losses.

“The key point is to create a neutral position on each share of stock,” Verseput said. Once that’s accomplished, he’ll never again have to worry how Washington’s actions affect the price.

In Florida, Michael Martin, chief investment officer of Maryland-based Financial Advantage, is keeping the status quo for the 200 families for whom his firm manages money. That means a 10 percent bet on gold, a dialed-down exposure to stocks and only short-term positions in bonds to protect against inflation.

“We think that the background environment is not going to change much because of the election. And the trajectory is scary, and that’s what our portfolio is built for,” Martin said. “We’re not changing the portfolio because of the election.”

And back in New York’s Times Square, one visitor is simply relying on faith.

“Markets go up and down, and just I kind of know that over the long haul, it will be up,” said Anjanette Potter, 40, an administrator at the Episcopal Diocese of Idaho in Boise.

What makes her so confident? Her retirement is managed by the Church Pension Group.

“They’ll do the best with it,” she said.

Podkul is a journalist in New York.

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