On November 2, 2004 while Americans voted, flawed exit polls (indicating among other things that Kerry would carry Florida, the popular vote, and the Presidency) prompted the market to vote on a perceived Kerry Administration. As we have argued before, the prospect of a “President” Kerry repealing the Bush tax cuts was a chilling prospect for the economy (see In the Mold of Jimmy Carter: The Kerry Tax Plan).
During his campaign, Senator Kerry made it very clear that he intended to repeal the Bush tax cuts for the top 2% of all wager earners. We have stated that such a policy would lead to dark times for capital markets, as higher taxes will prompt investors to demand higher pretax returns forcing valuation levels lower. Our argument supporting this conclusion is briefly summarized below:
An investor who is willing to pay $1000 for an investment when taxes are 0%, may only be willing to pay $500 for that same opportunity should the tax rate increase to 50%. The reason for this is very simple. If an investor requires a 10% after tax return and taxes are 0%, then the pretax return an investor would demand of a company would also be 10%. If the tax rate is 50%, however, the investor would need a 20% pretax return to generate the same required 10% after tax return. The only way to achieve that result is to pay less for the project, since taxes do not make projects more efficient, but just generate less after tax cash for the investor. The market is nothing more than a compilation of thousands of projects; as a result if taxes go up investors require a higher pre-tax rate of return leading to lower market prices.
As word of a Kerry “Presidency” spread across the Internet at approximately 2:30 PM EST, the market began to assimilate the ramifications of this new administration. At 2:00 PM EST, the market was up approximately 70 points on the Dow. In the 90-minute span from 2:30 PM EST until the market closed, however, the market registered a 70-point decline. The implications were very clear — a Kerry “Presidency” would lead to higher taxes and lower market valuations.
Since there is so much noise in market movements, it is rare to be able to address market-oriented questions with high degrees of certainty. One can argue that there may have been several reasons why the market tumbled at the thought of a “President” Kerry. These reasons may have included concerns over his ability to fight terrorism, doubts regarding his national health care plan, or anxiety over his uncompetitive protectionist policies. While each of these issues has merit, the policy Senator Kerry pushed harder and stronger than any other was his insistence on reversing Bush’s tax reductions.
In any event, there is no arguing the negative market reaction to a Kerry “Presidency”, nor the equally positive market reaction the following day once it was known that President Bush was re-elected. The market has clearly registered its vote and it is for Bush, and lower taxes.
