• It's Here!

    Etf Pro

    Get the big financial market moves right, bullish or bearish with Hedgeye’s ETF Pro.

Conclusion:  It appears increasingly likely that Republicans will gain some political control in the midterms, which should put the Bush Tax cuts squarely in play for an extension.  This would be positive for equity valuations in the short term.

I’m not sure even anyone has ever said this, but I will for the first time, polls don’t lie, people do.  Now, obviously, polls can lie, but in the aggregate they should tell us the story if they are implemented in a statistically relevant manner.  For the sake of argument, we will assume that the polls in the Real Clear Politics aggregate are accurate assessments of the political situation in the United States.

As it relates to the 2010 midterms, the polls suggest that the House Democrats will win 202 seats, and Republicans will win 201 seats, and that there are currently 32 toss-up seats.  While in the Senate, the polls suggest that 49 seats will go Democrat, 43 seats will go Republican and that there are currently 8 toss ups.  Now, obviously, since the full House is up for re-election every two years, it more accurately reflects the political wind of the country.  Currently, the political wind is blowing sharply to the right.  So much so that if the election were held today, the Republicans would have a real shot at regaining the House.

It is likely that the potential for Republican share gains only accelerates into the midterms given President Obama’s approval rating.  According to the Real Clear Politics aggregate for President Obama Approval, the President negative spread, so the difference between the positive approval rating and the negative approval rating, is -4.5.  The math behind this is a 45.1 approval rating and a 49.6 disapproval rating.  This negative differential is the lowest of President Obama’s first term, and is highlighted in the chart below.

Tailwind Into The Midterms - 1

In our morning meeting, Keith posed a fair question to me, which was who is the Republican front runner for the Presidency in 2012, and the answer was, I don’t know.  While President Obama is currently struggling with his approval rating and the Republicans would win in a generic head to head to poll in 2012 by 6.0 points, there doesn’t appear to be a Republican candidate that, as of yet, has stepped into the forefront.  With heightened concern about the debt, it seems likely that a practical and fiscally tested candidate might do the trick, but as of yet we aren’t sure who that person is going to be.

Between now and the 2012 Presidential election, President Obama’s approval rating and potential loss in a generic head to head ballot is most relevant for the upcoming midterms.  Those candidates in tight races will likely not want to be seen as associating with an unpopular President, but as a result won’t have the President’s bully pulpit and funding machine to utilize either.  Regardless, one point is becoming increasingly clear, the Republicans have a tailwind heading into the midterms.

Interestingly, a key implication of the Republicans taking back a combination of either the House (likely) or Senate (less likely) is that an extension of the Bush tax cuts could be firmly in play.  In fact, Paul Krugman, even noted this today in his New York Times column when he wrote:

“But Washington is providing only a trickle of help, and even that grudgingly. We must place priority on reducing the deficit, say Republicans and “centrist” Democrats. And then, virtually in the next breath, they declare that we must preserve tax cuts for the very affluent, at a budget cost of $700 billion over the next decade?”

As it relates to our portfolios, the two key components of the Bush Tax cuts that are relevant are the capital gains tax and the tax on dividends.  In a complete roll back of the Bush tax cuts, these taxes would go from 15% to 39.6% and the capital gains tax would go from 15% to 20%.  Inherently this policy has a direct impact on stock valuations, specifically related to high dividend paying stocks.  To the extent that these tax cuts are preserved, it should be positive in the short term for equity valuations.

Of course the debate and discussion over tax policy is a long and nuanced one, which would take up more wind and paper than this simple research note has allotted to it, but we just wanted to highlight that increasingly it seems that with the Republicans likely to gain political power in the midterms there will be an impact on tax policy, which may be marginally positive for stocks in the short term.

Of course, perhaps the most compelling evidence to keeping the tax cuts in place is that former Fed Chairman Greenspan recently came out against them when he said in a New York Times phone interview on August 6th:

“I’m in favor of tax cuts, but not with borrowed money. Our choices right now are not between good and better; they’re between bad and worse. The problem we now face is the most extraordinary financial crisis that I have ever seen or read about.”

Indeed, Mr. Maestro.

Daryl Jones

Managing Director