Obama Victory Unlikely, Says Mr. Market

Until recently, it was more or less a forgone conclusion that Barrack Obama would beat John McCain and become the next President of The United States. While the race has tightened, the major polls continue to show Obama winning the Electoral College contest, and market based forecast mechanisms such as Intrade.com show him with a 50% lead to win the election (8/6/08 Intrade data shows Obama to have a 60% chance to win the election vs. 40% for John McCain.). Unlike past elections that seem to have marginal differences between the candidates, this one is quite different. Barrack Obama is proposing an extensive set of tax increases on income and capital that have very negative ramifications for the stock market. Further, given the likelihood that Democrats will increase their control of Congress in 2008, Obama should easily pass his tax wish lists. Therefore, smart money will evaluate the odds of an Obama victory and take appropriate action. In this case, it is instructive to answer, “What area of the economy will be negatively affected by a President Obama?” The answer: growth stocks. Lets us first explore why Obama is bad for growth stocks, and then evaluate what the market is saying about an Obama victory.

In order to appreciate how Obama’s policies affect stock prices let us first review some basic concepts behind valuing a stock.

Example 1- No taxes, No cash flow growth

Company A is expected to generate $100 of cash flow forever, and investors require a 10% return. Through the wonders of algebra, the value of a company with these characteristics is captured by the following formula:

$ Flow / Investor Required Return, or $100 / 10% = $1000

So the value of a company that is not growing its cash flows is simply its current cash flow divided by the investor’s required rate of return.

Example 2- No taxes, Positive cash flow growth

Now lets assume that Company B also has $100 of cash flow, but it will grow at an annual rate of 5% a year. Again the wonders of algebra, the value of a company with these characteristics is captured by the following formula:

$ Flow / (Investor Required Return – Cash Flow Growth) or

$100 / (10% – 5%) = $2000

So the value of a company that is growing its cash flows is simply its current cash flow divided by the difference of the investor’s required rate of return and the cash flow growth rate.

Example 3- Taxes and Investor Required Rates of Return

In a world with no taxes, investors simply decide what they want to earn on their investments and then go shopping for investments that give them a satisfactory return for their capital. However, once the government begins to tax capital gains and dividends, investors must evaluate their investment opportunities on an after tax basis, which adds an extra layer of complexity to understand stock valuations. Lets evaluate how the investor required rate of return changes when the tax rate on capital gains increases from 0% to 28%. If investors require a 10% rate of return when capital gains taxes are 0%, those same investors will require a 13.9% required rate of return when the capital gains tax rate increases to 28%. Now lets value Companies A and B when investors have to pay capital gains taxes.

Company A: $100 / 13.9% = $719
Company B: $100 / (13.9% – 5%) = $1124

Notice that as taxes entered into the equation, Company A’s value fell by 28% (from $1000 to $ 719), while Company B’s value fell by 44% (from $2000 to $1124) illustrating how capital gains taxes affect growth and non-growth or “value” oriented companies differently. In other words, growth stocks are more severely affected (positively and negatively) by changes in capital gains tax policies as their cash flows are “back end” loaded.

Because changes in tax policy have such a dramatic effect on company valuations, market actors vigilantly analyze the likelihood of changes in tax policies and act accordingly. With respect to Obama, he has been very clear that he intends to increase taxes on capital gains and dividends from their current level of 15%. The exact level he seeks is unclear, but in past discussions he has indicated he will seek rates between 28% and 39%. Clearly, a President Obama will bring higher taxes and lower market valuations. But more specifically, as seen by our examples above, growth oriented stocks will suffer much more than value type stocks if higher capital gains taxes become part of the tax code.

This creates a unique and unbiased barometer of how likely Obama is to win this November, namely the relationship between growth and value stocks. Specifically, the more likely November brings a President Obama, the more growth stocks should under perform value stocks. The reason for this is very simple; as an Obama win becomes more likely investors will look to exit from growth stocks, causing them to sell-off and under perform stocks less affected by such tax increase. With the billions of dollars stake, investors have tremendous incentives to properly analyze and get to the right answer, unlike TV talking heads that inject their emotions, about who will win this coming November.

So what is the market saying? Through August 5, 2008, growth stocks are outperfoming value stocks as evidenced by the spreads between the mega cap value and growth stock ETFs tracked by Vanguard. Particularly interesting, value stocks tended to do as well or outperform the growth stocks through April. However, as it became likely that Obama would secure the nomination, growth stocks have significantly outperformed value stocks, indicating an Obama victory is unlikely. I cannot help but think that Hillary was indeed the stronger general election candidate.

Given the billions at stake, understanding how the market votes with its dollars everyday is likely to provide a more insightful glimpse to the election’s outcome than main street media pundit predictions or daily tracking polls. While much can and likely will happen between now and November to change things, today the market is clearly and confidently betting that Obama’s act is not yet ready for prime time.

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12 Responses to “Obama Victory Unlikely, Says Mr. Market”

  1. Mike Harmon Says:

    Great Blog post. I am going to bookmark and read more often. I love the Blog template if you need any assistance customizing it let me know!

  2. Don Landers Says:

    I hope you are right. Our economy will be a disaster under Obama. Our deficit will skyrocket, our dollar will plunge. People think gas is expensive now. Ha! How about workers who think too many jobs have been moved offshore already? Try Obama’s tax plan out and watch the exodus of business from America. Wake up people!!!

  3. Curtis Says:

    Good post, but what other forces could cause a shift to growth stocks besides tax policy expectations? Perhaps rising inflation? If inflation expectations rise, people require more return on their investment to make up for it. There has to be more at work here than just tax policy, and how can you account for all other factors?

  4. rresendes Says:

    MH – Thank you, read early read often

    DL – In general a better understanding by our pols between policy and actions would certainly be a step towards restoring people’s belief in Washington

    C – Increasing inflation would definitely cause a gap between growth and value stocks, but opposite of what you say. Increasing inflation will cause growth stocks to under perform. But your point is a fair one, there are likely other issues at work, but the tax one is the most obvious one at the moment, easy to identify and study. Given those factors, the Sutton Law applies.

  5. Top Posts « WordPress.com Says:

    [...] Obama Victory Unlikely, Says Mr. Market Until recently, it was more or less a forgone conclusion that Barrack Obama would beat John McCain and become the next [...] [...]

  6. Pat Moroney Says:

    If voters vote upon the profitability of corporations then you may be correct, but most Americans are worried about health care, education and security.

  7. Alex Says:

    I found your site on technorati and read a few of your other posts. Keep up the good work. I just added your RSS feed to my Google News Reader. Looking forward to reading more from you down the road!

  8. The Palin Barracuda Index « Capitalist Nexus Says:

    [...] Palin Barracuda Index I discussed here how capital gains taxes affect stock prices, and here how this effect is magnified for growth stocks relative to value stocks.  Essentially, as capital [...]

  9. Palin Barracuda Index - 9/12/08 Update « Capitalist Nexus Says:

    [...] The purpose of this index is to measure how the market assesses the likely change in tax policy in the upcoming presidential election.  Increases in the index indicate the market feels a  McCain victory is more likely, while decreases indicate an increased probability of an Obama victory.  The tension between these candidates, boils down to  keeping capital gains taxes low, and trying to control and/or reduce the size of government versus increasing capital gains taxes and expanding government’s role in the economy.  Given the contrasts between McCain and Obama in these areas, examining the relative returns of growth and value stocks seems like a natural way to quantify the market’s view as to how the race is progressing.  For a review of how taxes and inflation affect growth and value stocks look here.  For a specific look at how taxes affect growth and value stocks look here. [...]

  10. Tax Guy Says:

    I’ve been involved in taxations for longer then I care to acknowledge, both on the individualized side (all my working life-time!!) and from a legal viewpoint since passing the bar and pursuing tax law. I’ve provided a lot of advice and rectified a lot of wrongs, and I must say that what you’ve posted makes utter sense. Please persist in the good work – the more people know the better they’ll be armed to comprehend with the tax man, and that’s what it’s all about.

  11. Bibi Says:

    Interesting. Thanks!

  12. Aguada Says:

    Interesting. Thamks!;

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