BULLS & BEARS: Don't expect market assumptions to be true

July 9, 2007

The other day, a client asked me the following question about the stock market: "How are we going to play the downside when the next president is a Democrat and raises taxes?"

That question has three assumptions in it:

Presidents who are Democrats raise income taxes.

The stock market will drop if taxes are raised.

The next president will be a Democrat. For more than five decades, tax rates on personal income have basically been dropping. In the 1950s, the maximum tax bracket for earned income was a whopping 92 percent. By the 1960s and 1970s, the maximum rate fell to 70 percent and dropped again to 50 percent in the 1980s. Today, the top rate is 35 percent.

There have, however, been three times in post-World War II history when tax rates did blip up a significant amount: From 1950 to 1952, under Democrat Harry Truman, the top tax rate rose from 82 percent to 92 percent; in 1968 and 1969, under Republican Richard Nixon, the maximum rate jumped from 70 percent to 77 percent; and the third bump came in 1993, under Democrat Bill Clinton, when the rate went from 31 percent to 40 percent.

So it seems Democrats do have the upper hand on tax hikes-although the Clinton tax raise had its origin with George H.W. "Read my lips: no new taxes" Bush. Talk radio may disagree, but I would have to say both parties are equally at fault.

So now to assumption two: In the past, when taxes inflated, did the stock market deflate? To be fair about the returns, let's look at how the market did starting with the year before the tax increase, the years of the increase, and the year following the tax hike.

From 1949 through 1952, the stock market had four consecutive double-digit years, and the S&P 500 blasted up 128 percent. During the 1967-1970 "Tricky Dick" time frame, the market gained three years and lost one but gained a total of 29 percent. The final Bush/Clinton (to be fair) tax increase encompassed only three years, from 1992 through 1994-a period when the S&P 500 gained a total of 19 percent.

So of the 11 years before, during or after a tax increase, only one showed a negative rate of return. Under normal times, the market would drop three or four years out of 11. And the average gain for all those years was 13 percent, with 1969-the sole losing year-down 8 percent. Again, 13 percent is better than the long-term market average.

You might not like tax increases, but the market doesn't seem to mind them.

Now to the last assumption that the next president will be a Democrat.

When you consider Iraq, oil prices, Bush's lack of popularity, and throw Scooter in to boot, conventional wisdom would say a Republican doesn't have a prayer. But since when is wisdom conventional? Besides, the election is a long way away, which gives the candidates plenty of time to pray.



Gilreath is co-owner of Indianapolis-based Sheaff Brock Investment Advisors, money management firm. Views expressed are his own. He can be reached at 705-5700 or daveg@sheaffbrock.com.
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