Investors have gotten used to uncertainty, and even volatility. But the next few months present an unusual set of possible scenarios, even for these unpredictable times.
The U.S. presidential candidates, Barack Obama and Mitt Romney, offer a strikingly different set of policies for taxation, government spending and aid to the economy. Democratic President Obama clearly favors an active government role in the economy, ranging from infrastructure spending to funding for scientific research to vigorous regulation. Republican nominee Mitt Romney, by contrast, wants to downsize government and minimize its role in the economy. As Romney said during the second presidential debate, "government doesn't create jobs."
In Congress, meanwhile, Democrats and Republicans are less inclined to compromise than they have been in decades. That means that whoever controls the government after the November election may have a more pronounced effect than usual on the nation's economic future.
Government policies don't directly determine the long-term direction of the stock market, but abrupt changes in policy could very well cause ups and downs over the next several months. Uncertainty alone could generate a funk. "It would not be too surprising if stocks fell in this environment," George Perry of the Brookings Institution wrote recently. "Anyone who cannot afford a decline because they have a near term need for their capital should realize they are risking losses."
But beyond the next few months, there could be many opportunities for gains. Here's how Wall Street is gaming the stock-market odds under three scenarios:
The status quo. If Obama wins in November, and control of Congress remains divided between Democrats in the Senate and Republicans in the House, stocks might dip briefly as a sign of disappointment that Romney's business-friendly policies are off the table. But the bigger issue will quickly become the "fiscal cliff" — the huge set of tax hikes and spending cuts due to go into effect at the end of the year, if Congress lets them.
Divided government would undoubtedly produce a tense lame-duck session in which the best outcome is a last-minute deal to avert a series of changes that could lop five percent off the nation's GDP and instantly cause a recession. But it's more likely there will be no quick deal. Congress could put off the whole set of decisions for six to 12 months, while it works on a long-term solution to the mushrooming national debt. But that would probably bring another downgrade in the U.S. credit rating. On the whole, a continuation of the current gridlock would probably produce a roller-coaster stock market, with a rally likely only if there's a convincing "grand bargain" that seems to settle the biggest questions about tax reform, entitlement spending and unsustainable deficits.
The outlook for investors may hinge on Obama's ability to compromise. "There could be significant upside for stock multiples in a second Obama term if the president tacks to the middle and finds common ground with Republicans in the House," investing firm UBS advised in a recent report. "However, given deep ideological divisions between parties, we are not optimistic that comprehensive tax and entitlement reform will be addressed to the market's satisfaction."
A Republican sweep. If Romney were to win the presidency and Republicans took complete control of Congress, markets would soar for two reasons. First, Romney's plans to cut taxes and slash regulations would be seen as a boon for business. Second, single-party control in Washington would make it more likely that Congress and the White House could reach a comprehensive deal on taxes and spending. (That would be true if Democrats took complete control as well, although that seems highly unlikely, especially in the House.)
But not all is rosy in this scenario. Romney has said he wouldn't reappoint Federal Reserve Chairman Ben Bernanke in 2014, when his term expires. Despite some misgivings about the Fed's aggressive quantitative easing policies, Wall Street has grown comfortable with Bernanke's easy-money policies, which the Fed has said it will keep in place until there's convincing evidence of a strong recovery. That has put a floor beneath stock prices and allowed big companies to stockpile cash. "Given the market's penchant for liquidity over the past several years, we believe concerns over tighter monetary policy could create a headwind in 2013," UBS warns.
A Romney victory with a divided Congress. This could produce a manic market leading up to Inauguration Day, as stocks first cheer a Romney victory, then retreat as the end of the year approaches. If Romney were due to be sworn in come January, House Republicans would have little incentive to make a deal on the fiscal cliff during the lame-duck session. Instead, they'd wait until their man was in the White House, which would give them the most leverage. So the economy might actually go over the cliff, with the expectation that it would be rescued sometime after Jan. 20.
It's hard to predict how Democrats would react if they still controlled the Senate. But that might force Romney to move toward a more moderate set of proposals that cut taxes and spending less than he'd prefer. The same would go for President Romney's nominee for Fed chairman in 2014, since that person would have to be confirmed by the Senate.
Overall, a middle-of-the-road solution to the government's tax and spending mismatch would be ideal, since in theory it would minimize the economic pain today while still forging a way to get the government's debt under control. That may be precisely what it takes to achieve some of the more optimistic stock market forecasts, such as Piper Jaffray's prediction that stocks will rise 16 percent over the next 12 months and 37 percent over the next 24. The only caveat: It's hard to be bullish on stocks when the forecast depends upon compromise in Washington.
Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.