January 20, 2004
Dow Jones Average: 10,601
S&P 500 Index: 1,140
Election Year Economic Policy
As newly elected presidents take office they inherit
the economic conditions and foreign policy issues left by their predecessor.
Given their considerable egos, all presidents believe that they can
improve upon the conditions they inherit, or at least lay a foundation
for future improvements. Presidents who take over after a period of
strong economic growth may not be able to better their predecessor’s
record, but they will always make the case that they did as well as
anyone could under the circumstances. When voters head to the polls
the outcome is determined as much by perception as reality.
With influence over tax policy, government spending, and foreign affairs,
sitting presidents are in a powerful position to mold public opinion
by Election Day. As the standard bearer for their political party
they feel particular pressure to win re-election and maintain the party’s grip on the instruments of power, Presidents
tend to make the tougher, unpopular decisions in the first two years
of their four year term. With political survival on the line, policy
becomes increasingly expedient as elections approach. The policy decisions
made by presidents seeking re-election may please the public in the
short term, but can have negative consequences later on. Voters may
be swayed by election year economic policies, but investors should
be wary of such moves.
The clearest example of an election driven policy backfiring
in subsequent years was Richard Nixon’s decision to impose wage
and price controls. Richard Nixon assumed the presidency at the end
of the go-go sixties, an era of tremendous technological advancements
and a booming stock market. The stock market and economy started falling
soon after he took over as president. By 1971 he was faced with unemployment
of five percent and inflation of five percent, terrible numbers at
the time. Nixon felt that a weak economy in 1960 had contributed to
his defeat by John F. Kennedy, and he was worried that a troubled
economy would cost him again in 1972. Looking for a way to juice the
economy without increasing inflation, he settled on the idea of wage
and price controls combined with government stimulus. This was a shocking
proposal, as wage and price controls had last been used in the WWII
era and Nixon had vehemently opposed them. Wage and price controls
are generally considered to be a last resort economic policy, because
they interfere with the function of the free market and typically
create a huge spike in inflation when removed. Obviously, President
Nixon believed that the success of his re-election drive in 1972 called
for unusual measures.
Wage and price controls became law in August of 1971,
one year before the election. The economy advanced in 1972 without
an increase in inflation, the stock market gained 17 percent, and
Nixon was re-elected in a landslide. By 1973-74 the economic wheels
were coming off, the wage and price controls were relaxed, inflation
accelerated, the economy went into a deep recession, and the stock
market collapsed. While Nixon resigned over Watergate, the disastrous
state of the economy in 1974 did not help his standing with the public.
The mess created by the imposition of wage and price controls finally
ended years later when Jimmy Carter lifted the remaining price controls
on the critical oil and natural gas sectors. Carter is the president
most closely associated with high inflation, high interest rates,
and lines at the gas station, even though these problems were largely
caused by the flawed economic policy of his predecessors. Rightly
or wrongly the public holds the sitting president accountable for
the conditions that exist on Election Day.
There are similarities between the Nixon and Bush presidencies.
George W. Bush
assumed office after a decade of technology driven growth, and the
greatest boom in U.S. stock market history. The economy was already
fading by the time he took office much as it was when Richard Nixon
took over in 1969. The actions President Bush has taken to revive
the economy have become more dramatic as the time to re-election has
grown shorter. Accelerating future, scheduled tax cuts to the summer
of 2003 was his boldest and most controversial attempt to kick the
economy into high gear. This policy has caused an explosion in the
federal budget deficit, a problematic situation that either he or
a successor will grapple with after the election.
From a political perspective tax reductions are always a winner. Any
sort of tax
reduction comes as welcome relief for the majority of Americans living
check to check, or trying to save for some bigger ticket item. The
possible negative effects of huge budget deficits are not easily quantifiable
and are too far in the future to concern most people. There are strong
constituencies in the country that support spending programs and tax
reductions, but a distinct minority of fiscal conservatives in favor
of balanced budgets.
The International Monetary Fund recently warned that U.S. budget and
trade deficits pose a significant threat to the world economy in coming
years. Robert Rubin and Paul O’Neil, former Secretaries of the
Treasury, have expressed strong concerns that high deficits will lead
to some combination of inflation, higher interest rates, tax increases,
and the inability of government to meet its stated obligation to retirees.
None of these unpleasant outcomes are likely to be apparent before
Election Day in 2004. While voters may be focused on conditions in
2004, investors who expect to be holding either stocks or bonds for
a year or more have to think about 2005 and beyond.
Current Strategy
The economy strengthened over the past six months as
sales of high end technology
products complemented already robust home and auto spending. Higher
income
individuals stepped up their spending on items such as high definition,
plasma TVs,
and laptop computers. U.S. exports expanded as a sharply lower dollar
helped U.S. companies compete in world markets. In recent years the
U.S. economy has been
stimulated by record low interest rates, substantial tax cuts, and
a falling dollar.
The question is whether economic growth can become self-sustaining
in the absence
of further stimulus
Stock prices reflect expectations for further robust
economic growth in a low inflation, low interest rate environment.
In other words, stocks are priced for the ideal economic environment.
The median price/earnings ratio for stocks is now much higher than
it was at the peak of the market in early 2000. If the economy was
to stall even briefly, or inflation and interest rates were to rise,
the stock market would most likely react quite negatively.
We have the greatest respect for the investment acumen
of Warren Buffet, unquestionably the most successful investor of the
past forty years. In recent years Buffet and his staff have found
bargains in everything from real estate trusts and building supply
companies to junk bonds and insurance stocks. He seldom misses a bargain.
Buffet’s investment holding company, Berkshire Hathaway is currently
sitting on a record 27 billion dollars in cash reserves, because he
and his staff can not find undervalued stocks in the U.S. market.
While our criteria for stock selection is somewhat less exacting than
Buffet’s, we always try to buy stocks at prices that allow some
cushion for less than ideal conditions. Buying stocks in the current
U.S. market environment is a high wire act with no safety net.
With stocks in the U.S. at high levels we have turned some of our
research effort to overseas companies. We purchased companies such
as Kyocera and America Movil,
because in our opinion they had higher growth prospects at significantly
lower share valuations than comparable American companies. We will
continue to search worldwide for reasonably priced stocks and fixed
income investments
