A new party in charge of the House of Representatives, a chastened president, a new economic team in the White House—there's certainly plenty of change afoot in Washington. Along with it, of course, there's no shortage of debate over deficits, taxes and regulation. But as politicians zero in on their pet issues, investors have a more pressing question: How much of it will matter when it comes to the markets?
If history is any guide, the short-term answer is not much, and that could wind up being good news for people who own stock. The third year of a president's term—regardless of whether the person in charge is a Republican or Democrat—has been bullish for stocks. Since 1945, Standard & Poor's 500-stock index has increased more than 17 percent, on average, during the lucky third years, compared with an average rise of less than 6 percent in the other three years of a president's term. Perhaps even more surprising, since the end of World War II, the stock market has never lost money during the third year of a presidential cycle.
But don't thank the politicians: Experts say the jolt to the markets is usually delivered by the Federal Reserve, which has typically lowered the cost of borrowing money regardless of which party was in the White House. True to form, the Fed has once again restarted the printing press in an effort to drive short-term interest rates to near record lows, adding fuel to the fall stock market rally. Fed Chairman Ben Bernanke says the Fed is keeping rates low to fight high unemployment and fend off potential deflation, or falling prices. But Jeremy Grantham, chief investment strategist for GMO, which manages $107 billion, says the lower rates encourage more people to invest more money in the markets. The result, he says, is that the wealth effect from rising stock prices lifts the economy in the fourth year of a presidency, "just when it is needed."
If equities do get their historic lift again this year, strategists say, some of the biggest benefits could flow to stocks that have been dogged by recent legislation, such as those in the health care sector. Ed Yardeni, an independent market strategist, says the sector could get a boost if Republicans get "grudging rollbacks" of some provisions in the health care law that passed last year. Some strategists say the outlook is still foggy for financial stocks, though. Stuart A. Schweitzer, the global markets strategist at J.P. Morgan Private Bank, says financial stocks will remain an "open question" until government regulators implement reforms and the economy improves.
On the tax front, Congress and the White House, of course, cut a deal to keep the Bush-era income-tax cuts in place for all Americans for the next two years. Republicans and Democrats agreed to keep the tax rate on dividends considerably lower than tax rates on ordinary income. Stocks that pay hefty dividends—recently a popular alternative to low-yielding bonds—started to rally in the fall and could continue to benefit now that the low rate will be in effect for another two years. The partisan rancor over taxes certainly didn't stop companies from paying their shareholders more money. Last year the number of firms raising their dividends soared by 60 percent. Lee Rosenberg, president of ARS Financial Services in Jericho, N.Y., recommends blue-chip dividend stocks since their after-tax yields will be higher than the yields on many bonds.
The status quo on taxes could encourage more companies to raise their dividends, strategists say. But even if Washington changes its mind on dividend taxes, history actually is on the side of investors. Ed Clissold, global equity strategist at Ned Davis Research, says there have been only two major dividend-tax increases—in 1936 and in 1954. In both cases, Clissold says, companies kept increasing their dividends. "The tailwind of economic growth was greater than the headwind of tax increases," he says. But even if it doesn't, firms might instead opt to repurchase their own shares, a move that also could help investors.
Of course, other investment options that once attracted yield-hungry investors—bonds, certificates of deposit and money-market funds—are now saddled with paltry yields. Chalk that up, once again, to the Federal Reserve, whose rock-bottom interest-rate policy keeps the yields on fixed-income products extremely low. Even if the Fed goes whole hog on its plan to purchase up to $600 billion in Treasurys, Beth Ann Bovino, a senior economist at Standard & Poor's, predicts the policy will give only a "modest" boost to the economy, while keeping the yields on short-term bonds low.
Yardeni says interest rates on 10-year bonds might rise to around 4.5 percent (they started the year around 3.5 percent). If that happens, investors who plowed money into bonds or bond funds could lose money (bond prices move in the opposite direction of interest rates). Some strategists are recommending short-term bonds, which are less sensitive to rising interest rates, as well as high-yield bonds and emerging-markets debt.
Until more of the clouds clear in Washington, most financial planners aren't recommending radical changes in their clients' approach to their investments. Rosenberg, of ARS Financial Services, says that's like "putting on a raincoat and then finding out the weather has changed while you were getting dressed." And even with all the questions hanging over the markets, some money managers see a silver lining. Peter Vanderlee, who runs the $1.8 billion Legg Mason ClearBridge Dividend Strategy fund, says the uncertainty is creating some bargains, especially among the high-quality dividend stocks that he favors. "Even though the risks are pronounced," he says, "investment opportunities abound."
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