Capitol crunch
Social Security and tax reform are on Bush's investor-friendly agenda
Staying tuned to the news doesn't necessarily help you as an investor. There are always headlines that'll scare you away from stocks. Just look at last year. War. A falling dollar. Rocketing oil prices. Fears of higher inflation and interest rates. A too-close-to-call presidential election.
It's much the same as 2005 begins, but at least one uncertainty has been removed: the occupant of the White House for the next four years. Once that question was answered in November, nothing much else seemed to matter as stocks turned in a late-inning rally that helped the market score its first back-to-back bullish years since 1998-1999. The Standard & Poor's index of the 500 leading companies finished 2004 up nearly 11 percent, while many stock mutual funds (especially those with a healthy dose of small companies in their portfolios) did considerably better. "It was really a textbook election year in that the market was rangebound all the way until October," says Jeffrey Kleintop, chief investment strategist for PNC Advisors. "It really made sense to sit on the sidelines or buy and hold. In the end, stocks traded in sort of a hockey-stick pattern."
But while the new year brings some of the same uncertainties as last year, there's also a new element in the worry mix. President Bush, fresh off a decisive victory--at least compared with his 2000 win--has declared his intent to move forward with a bold domestic agenda to which investors need to pay close attention.
First and foremost is Bush's promise to tackle the issue of Social Security--described in a leaked E-mail that made the rounds of Washington last week--which portends a titanic struggle that could affect millions of Americans for the rest of the century and beyond. As part of his "ownership society," Bush favors giving workers the chance to invest a portion of their payroll taxes in private investment accounts. But this will most likely be twinned with cutbacks in promised benefits for future beneficiaries--in other words, younger workers. "It's going to be a real uphill fight," says Tom Gallagher, political analyst and managing director at research firm ISI Group.
Gallagher notes that when Franklin Roosevelt and Lyndon Johnson passed their sweeping New Deal and Great Society programs, they commanded far larger congressional majorities than the GOP's fairly slight hold on power in today's House and Senate. Not that passing Social Security was a piece of cake back in 1935. "Social Security was a very controversial program from the start," says Eric Patashnik, associate professor of politics and public policy at the University of Virginia. "Even in 1936, Republican presidential nominee Alf Landon was campaigning to repeal it."
Power shift. The market's ups or downs this year will most likely pale in financial importance compared with the outcome of the Social Security fight. And although Republicans today aren't campaigning to repeal the retirement program, they are pushing for substantive changes. In fact, the changes are so historic, they might need a somewhat historic route to passage. "As we saw during the Clinton healthcare debate, people in this country don't like radical change," says Greg Valliere, political analyst at the Stanford Washington Research Group. "So this thing is going to move very slowly."
So slowly, perhaps, that any reform, if it happens, might get done toward the end of Bush's term--even though that traditionally is when a second-term president sees his political power ebb. But Valliere thinks the GOP could add to its Senate totals in the 2006 off-year election, perhaps moving "close to the magical 60" number, which could help cut off any Democratic filibusters on reform.
While no one underestimates the political battle that will unfold on Capitol Hill, Bush has shown a willingness to plow ahead even when the beltway punditocracy and editorial pages of the mainstream media counsel caution. One needs only to think of his decision to invade Iraq or cut taxes. Add in his desire to continue tweaking the tax code in favor of investors, and it's clear 2005 will be every bit as exciting--indeed, unnerving--for investors as the year just ended. One easy way to handicap the action on Social Security, says Gallagher, is to look at the nature of the debate. If months from now, Bush is still making the case that Social Security is a program in crisis, the odds of any major reform will probably be slim. But if the debate has progressed to determining what kind of change is needed--with the Democrats having one plan, the GOP another--that is just the sort of battle that in the past Bush has shown he can win.
Already, Bush has left a legacy for investors in the massive cuts in income tax rates he pushed through Congress in his first term. Included in those was a cut in the tax on dividends, which has spurred many companies to increase their dividends or to begin paying them for the first time. Although they are often overlooked by investors clamoring for capital appreciation, dividends provide a good deal of the overall return a stockholder receives over time. "President Bush's tax cuts are just the gift that keeps on giving," says Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson in Chicago, referring to the 2003 cuts in dividend and capital-gains taxes. He looks for the economy to grow at a 4.2 percent clip this year, powering the stock market to a 20 percent gain in 2005.
Which specific sectors might lead the way in 2005? Although geopolitical tensions tend to boost oil prices, Henry McVey, chief U.S. investment strategist at Morgan Stanley, sees rising energy demand as all the reason you need to buy oil-related stocks, particularly those of firms that are buying back stock and increasing dividends. He favors Schlumberger, ConocoPhillips, and Williams Cos. He also likes the capital-goods sector--especially in defense and aerospace--which he says has the power to raise prices. Among his top names are Lockheed Martin, Tyco, and Flowserve.
In general, many of today's current market trends bode well. Wall Street is looking for another year of solid economic growth with benign inflation and interest rates. That may well pan out, but as Alfred Goldman, chief market strategist at A.G. Edwards in St. Louis, notes, market history is telling him to be cautious. "The biggest problem we have is that we have a bull market that is getting long in the tooth by historical standards," Goldman says.
Bull runs usually last two or more years between major corrections. This current upturn in prices is now 26 months old, dating back to October 2002. And even though most of the major market averages are still a good stretch of the legs from their 2000 highs, they have posted some solid gains during this advance. The S&P is up 53 percent, the Dow 46 percent, and the Nasdaq 89 percent, though the Nasdaq would need to more than double from its current 2100 to match its record 5048 level reached in March 2000 (story, Page 56). Corporate profit growth is also slowing from its lofty perch of recent years as many of the gains from cost-cutting and productivity improvements are giving way to higher raw materials prices and the need to hire new workers and expand capacity.
The new year started off on a sour note, as stocks posted losses early last week. The culprit? Strong factory orders, which traders took as evidence that the economy may be growing fast enough that the Federal Reserve Board will have to step up its go-slow interest-rate-hike policy. It didn't help when minutes were released of the Fed's December meeting, which showed policymakers voicing concern about the dollar and inflation.
Another aspect of market history also is troublesome. This is a post-presidential-election year, "and those tend not to be the greatest years," says Jeffrey Hirsch, editor of the Stock Trader's Almanac. He notes that since World War II, stocks have gained a meager 3.7 percent on average during the first year of a presidential term. "During the first two years of a term is usually when you have your recessions, depressions, and wars." There is a caveat to this historical fact, however. When the same party stays in power, the market does pretty well, gaining more than 10 percent. There's one added caution, though it's one Hirsch doesn't take too seriously since he can't come up with a fundamental reason why it should be so: A year ending in "5" has not been a losing year for stocks in more than a century.
Put history aside for a moment, and Robert Sweet, economist and managing director for MTB Investment Advisors, likes today's economic fundamentals. "I think the economy will show growth of around 4 percent without any runaway inflation," he says. "You'll see the term 'not too hot, not too cold' used a lot. And I think we'll end with the market up around 6 or 7 percent." A bit more bullish is Edward Yardeni, chief investment strategist at Oak Associates. He's looking for the S&P 500 to rise to 1385 by year-end from its current 1191 and for the Dow Jones industrial average to retest its all-time high of 11,723. Key to his forecasts is low inflation--right around 2 percent or so--which would help protect the Fed from having to suddenly ratchet interest rates sharply higher. "If inflation rises significantly next year, my forecast will be wrong," he told his clients in his year-end letter.
Checking inflation. Yardeni rests his forecast on a macro thesis that the unraveling of the Soviet Union and China's integration into the world economy have created increased global competition, which should keep worldwide inflation in check for years to come. He's also confident about his inflation outlook based on what happened in 2004. Even though oil prices soared from $34 at the start of the year to just over $55 and the dollar slid more than 8 percent on a trade-weighted basis--raising prices on imported goods--inflation remained tame.
Even so, Wall Street hates uncertainty, and this year could produce the kind that market mavens always have trouble figuring out--political. Give the market an earnings surprise and stocks immediately correct, sometimes too much--in which case value players step in to maintain equilibrium. But Wall Street has always had a hard time fathoming Washington. So if politics dominates the headlines again in 2005, the market could well do what it did for much of 2004: trade back and forth but barely budge until the uncertainty is resolved one way or another.
This story appears in the January 17, 2005 print edition of U.S. News & World Report.