Compass Financial - Weekly Market Commentary Nov 3 2008

LP L FINANCIAL R E S E AR C H

Weekly Market Commentary November 3, 2008 v4

Election 2008 Jeffrey Kleintop, CFA Chief Market Strategist LPL Financial

Highlights While the Presidential election gets almost all of the attention, we are even more interested in the Senate races. There is potential that in January the political party in the White House will also control both the House and Senate, with near filibusterproof margins. While there are many factors that affect stock market valuation, one, the potential for higher tax rates on dividends and capital gains, may already be fully discounted by the market. The potential for a retroactive dividend rate tax hike to the beginning of 2009 could prompt a large number of closely held public companies to make one-time, special dividend payments in the fourth quarter to take advantage of the 15% tax rate. Over the past three decades, investors appear to have displayed a strong preference for the incumbent party. Post election year returns averaged 18.9%, as measured by the S&P 500, when the incumbent party stayed in charge compared with -6.8% when the challengers won. However, we could be entering a new era, given the weak market performance of the current decade. Since the late 1920s, during the year after a presidential election the bond market has fared better under a Republican president, with government bond returns of 6.8%, than under a Democrat, 4.3%, as measured by the S&P 500. The worst case scenario is that the winners would not be known by November 5. While unlikely in the presidential race, given the anticipated electoral margin, uncertainty could be the case for the contested Georgia seat in the U.S. Senate. The Democrats’ margin in the Senate may not be known until a likely December 2 runoff between the top two candidates in that race.

Polls in battleground states show that the presidential election is shaping up to result in a much wider electoral margin than in recent elections, with Democrat Barack Obama in the lead headed into the election. While anything can happen, with the likely outcome of a Democrat in the White House and a wider majority for the Democrats in the House, we are most closely watching the prospects for a 60-vote, filibuster proof majority in the Senate for the Democrats. While the President has a lot of impact on foreign policy and trade, the Senate sets the pace on taxes, laws affecting business, and other issues of interest to investors. With Republicans having to defend 22 seats versus the Democrats’ 12 and the tide shifting toward the Democrats in most races, the 2008 elections are likely to result in significant gains for the Democrats in the Senate. In fact, we put the odds that the Democrats will capture 60 seats in the Senate at about 50%. Polls show seven Republican-held seats highly likely to shift to the Democrats: Virginia, New Mexico, Alaska, Colorado, New Hampshire, and North Carolina. If the Democrats win all six, they would only need to win three of all the other races to get to 60. It is widely held view that “gridlock is good” when it comes to governmental power. The performance of the markets after World War II tended to be better when power was divided among the parties—virtually eliminating sweeping changes. There will be no gridlock if the same political party is in power in the White House, House of Representatives and Senate, magnified by near filibuster-proof margins. Obama’s may not have to follow through on his claim that he intends to work with the other side of the aisle, as Democrats have a good chance of getting 60 votes in the Senate and upwards of 255 (compared to 180 for the GOP) in the House. This potential outcome creates heightened uncertainty for business leaders and investors surrounding the outlook for changes affecting the business climate. Of course, the worst case scenario is that the winners would not be known by November 5. While unlikely in the presidential race given the anticipated electoral margin, uncertainty could be the case for the contested Georgia seat in the U.S. Senate. The Democrats’ margin in the Senate may not be known until a likely December 2 runoff between the top two candidates in that race. The close race in Georgia, where incumbent Republican Senator Saxby Chambliss is running against former State Representative Democrat Jim Martin and Libertarian Allen Buckley. Based on the polling numbers, it is likely that no candidate will receive over 50% of the vote on November 4 and avoid a runoff election between the top two candidates on December 2. If the Democrats find themselves controlling 59 seats and are awaiting the Georgia runoff to determine whether they can get to 60, the race will garner

Member FINRA/SIPC Page 1 of 8

W E E KLY MARKE T COMME N TAR Y

a great deal of national attention, and the lingering uncertainty may weigh on the stock market, limiting any post-election rally. There is potential for a landslide for the Democrats and a “mandate” for change. The following is what the investment environment for various sectors might look like with a Democratic landslide:

Health Care ƒ Health care legislation probably is more of a 2010 event with more pressing focus on a fiscal stimulus package and tax hikes. ƒ Potential legislation on universal healthcare is a negative for the managed care industry, making private health insurance less profitable and shifting market share to government plans. More importantly, managed care could be hurt by Medicare Advantage changes to reimbursements. ƒ The threat to government control of pricing for pharmaceuticals has been priced in for years – with U.S. drug stocks trading at valuations comparable to counterparts in Europe, where health care is socialized. However, a Democrat-appointed new FDA head would likely have influence over the timing of drug approvals and advertising. ƒ Under comprehensive health care reform, many healthcare industries would likely benefit. For example, drug companies could experience increased demand as they did after Medicare Part D was introduced. Other industries including providers (hospitals, nursing homes), diagnostic labs, and even generic makers may benefit from Democrats’ healthcare proposals expanding healthcare coverage, emphasis on preventative care, and emphasis on generics.

Utilities ƒ Coal is the dominant fuel source for power utilities. With the highest proportion of costs attributed to energy of any industry, utilities are the most exposed to changing regulations on greenhouse gases that would be likely from Democrat-led executive and legislative branches of government. Some utilities have been preparing for anticipated changes, while some have not. As pressure for cleaner emissions rises, those power utilities with relatively “clean” production from nuclear, wind, hydro and other renewable sources will have the advantage over those that will need to undertake the costs of becoming “clean”. Even for those companies at the forefront of environmental stewardship, higher costs are likely. ƒ The exact emissions standards will be determined by politicians and that could be a lengthy process—consider the fact that coal-producing Appalachia has 12 seats in the Senate. Utilities are unlikely to commit to substantial outlays for new plants until the technical details are clear and they can safely adopt the technology best suited to the new rules. This delay may have the effect of slowing profit growth.

Financials ƒ New, more sweeping regulation is likely for this sector. We may see increased scrutiny and liability for predatory lending.

LPL Financial Member FINRA/SIPC

Page 2 of 8

W E E KLY MARKE T COMME N TAR Y

ƒ Democrats may enact legislation allowing bankruptcy courts to lower mortgage loans if values declined, change interest rates, and prohibit prepayment penalties—all negatives for lenders. ƒ Credit rating agencies may be negatively affected by potential legislation mandating a change in business model or banning consulting. ƒ The potential for a cap on the tax exemption for annuities above $1 million may be a negative for insurers. ƒ The potential for expansion of retirement savings plans may benefit asset management companies. ƒ Climate change initiatives may expand new trading markets such as carbon emissions and weather futures, and since venture capital and private equity investment in clean energy firms has surged, are likely to continue to be a boost to advisory and underwriting fees.

Energy ƒ Headline risk rises for energy companies; however, we doubt oil and gas firms will be subject to any especially negative actions, such as a windfall profits tax. ƒ Increased royalty payments paid by oil and gas companies for the use of public land and offshore sites may be an incremental negative for major integrated oil companies. ƒ An incremental positive for natural gas producers may be a climate change program for greenhouse gas emissions raising the cost of using coal. ƒ The delay in adding new capacity for Utilities, combined with the additional time frame to actually build the new generation plants, will likely lead to increasing natural gas demand to meet rising demand for power.

Industrials ƒ Congress may demand through regulation, taxation, and incentives that environmentally-friendly technologies like carbon capture, solar, and wind become a much larger portion of U.S. power generation, creating opportunities for companies that provide alternative power and delivery of alternative fuels. ƒ The companies tied to large defense programs could come under additional pressure, although companies that benefit from port security, chemical plant security and homeland security spending and regulation in general should benefit, as Democrats may increase funding in these areas.

Materials ƒ A fiscal stimulus package focused on highway spending may benefit the makers of aggregate and the construction companies. ƒ Extraction industries may face tougher environmental rules and enforcement. ƒ The potential for climate change initiatives invoke a wide range of new product opportunities for the chemical industry, including emission treatments, additives and catalysts for cleaner fuels and fuel cells, improvements in energy-efficiency through better insulation and lighter

LPL Financial Member FINRA/SIPC

Page 3 of 8

W E E KLY MARKE T COMME N TAR Y

weight materials, and new materials for solar panels and wind turbines. On the other hand, the chemical industry is a large consumer of energy as a raw material and in the refining process. Higher costs could come for hydrocarbons and other fuels, along with the potential capital and operating costs associated with complying with greenhouse gas emissions requirements.

Consumer Discretionary ƒ Potential copyright legislation under a Democrat-controlled Congress is likely to favor entertainment content providers. ƒ The Supreme Court ruling of April 2, 2007 upheld that the EPA has the authority to regulate carbon dioxide emissions and greenhouse gases. A Democrat-appointed head of the EPA will push automakers for higher standards for fuel efficiency. This new technology comes at a higher cost that consumers have been hesitant to embrace, and which may negatively impact already low profit margins in the industry.

The market impact of the investor tax cuts in 2003 that lowered dividend and capital gains tax rates to 15% was difficult to discern, given the geopolitical and economic environment at the time, and the impact of the reversal of these provisions may be equally difficult to discern separately from their macro context.

Consumer Staples ƒ Pro-union measures adopted by Congress may weigh on profitability and expansion by companies in this sector. ƒ Expanding ethanol use to 85% ethanol blends via tax incentives or mandates benefits ethanol producers. ƒ Potential extended FDA restrictions on tobacco products advertising could potentially benefit producers by saving billions while only slowing domestic consumption marginally as international growth continues. An increase in the tobacco tax could be a slight negative.

Information Technology ƒ Potential legislation supporting health care technology investment and a network potentially tied to Medicare reimbursement could be a positive for this sector. ƒ Climate change initiatives may boost semiconductor equipment companies with solar and energy efficiency products.

Telecommunications Services ƒ A change in the head of the FCC along with Democrats’ preference for network neutrality could be a positive for the smaller competitors at the expense of the largest players.

Tax Hikes of 2009 One of the ways the election impacts the markets is through the candidates’ stances on tax policy. The market impact of the investor tax cuts in 2003 that lowered dividend and capital gains tax rates to 15% was difficult to discern, given the geopolitical and economic environment at the time, and the impact of the reversal of these provisions may be equally difficult to discern separately from their macro context. We can see this difficulty by looking back at the stock market’s reactions to the news of a proposed investor tax cut and then the passage of those cuts:

LPL Financial Member FINRA/SIPC

Page 4 of 8

W E E KLY MARKE T COMME N TAR Y

1

High Dividend Paying Stocks Underperformed when Dividend Tax Cut Passed Performance of the Top 20% and Bottom 20% of Stocks in Russell 1000 Index by Dividend Yield High Dividend Payers Low Dividend Payers

70% 60% 50% 40% 30% 20% 10% 0%

Apr May Jun 03 03 03

Jul 03

Aug Sep Oct Nov Dec 03 03 03 03 03 Source: Factset, LPL Financial Research

Looking at the post-WWII relationship between investor tax rates and stock market valuations based on trailing price-to-earnings ratios, we can see that stocks may have already priced in a return to higher investor tax rates.

ƒ Initial details of the 2003 investor tax cuts began to appear in early December of 2002 with a statement from President Bush providing further insight into the package of tax cuts on January 7, 2003. Stocks slumped in December and January—even around the days details came to light—as investors were focused on the impending invasion of Iraq. The performance of both non-dividend paying and dividend paying stocks were very similar, despite the prospects for a cut in the dividend tax rate. ƒ Attention returned to the tax cuts in April 2003 as competing bills with various provisions moved through both houses of Congress. There was much uncertainty as to what the final tax cut elements were to be and whether any investor tax cuts were going to be passed. The tax bill narrowly passed in mid-May with the Vice-President Cheney breaking the tie in the Senate. The package including the investor tax cuts was signed by the President on May 28, 2003. In April and May (and over the rest of the year), the stocks of low or no dividend paying companies outperformed high dividend payers as stocks rallied powerfully and the invasion of Iraq got underway. During both of the above referenced periods, U.S. and non-U.S. stocks also performed very similarly, with the world focused on Iraq. The impact of the investor tax cuts in the United States did not result in U.S. stock market outperformance. Also, low and non-dividend paying stocks outperformed the high-dividend payers that would benefit most from the lower dividend tax rate. It appears that the tax cuts played little or no role in stock market performance. Possible reasons may be that investors discounted the effect on future dividends since the cuts were not made permanent, or that the effects on after-tax returns were deemed negligible relative to the macroeconomic and geopolitical drivers. In theory, stocks are valued by investors based on expected total return net of applicable taxes. For example, if dividend and capital gains taxes were each set at 100%, stocks would have little value to a taxable investor. It is reasonable to believe that the lower the tax rate, the more of the pre-tax total return on the stock market the investor keeps on an after-tax basis and, therefore, the more the investor would value the stocks. Looking at the postWWII relationship between investor tax rates and stock market valuations based on trailing price-to-earnings ratios, we can see that stocks may have already priced in a return to higher investor tax rates. John McCain has indicated he would seek to maintain the investor tax cuts of 2003 and lower capital gains taxes. Barack Obama initially indicated he would repeal the investor tax cuts (which are due to expire in 2011) and return the top dividend and capital gains rates to 39.6% and 20%. However, in recent months Senator Obama and his chief economic advisor have each talked about top dividend and capital gains rates of around 20-25%. These statements on tax policy suggest an investor tax increase under a President Obama. In the post-WWII period, investor tax rates most similar to these levels were in effect only during 1991-92 and 1997-2002. The late 1990s record high valuations for the stock market were well above current levels, but do not serve as a good comparison due to the impact of the internet bubble,

LPL Financial Member FINRA/SIPC

Page 5 of 8

W E E KLY MARKE T COMME N TAR Y

While there are many factors that affect stock market valuation – the potential for higher tax rates on dividends and capital gains may already be fully discounted by the market.

which distorted the overall market value. However, 1991-92 may offer a more comparable period for analysis. The macroeconomic and geopolitical backdrop included the aftermath of the S&L crisis, sluggish economic growth, the first Gulf War, pessimistic consumers, and a weakening dollar. During the period that the top capital gains and dividend tax rates were higher with each averaging just under 30%, stock market valuation, measured by price-to-earnings ratio on next twelve months expected earnings for the S&P 500 companies, was about 15—well above the current forward price-to-earnings ratio of about 10. While there are many factors that affect stock market valuation – the potential for higher tax rates on dividends and capital gains may already be fully discounted by the market. With Congress likely to push forward with higher tax rates than those cited by Obama during his campaign, it is also worth noting that the average price-to-earnings ratio was 12 during mid-1980s and mid-1990s when the top capital gains and dividend rates averaged about 35%. While many more issues then tax hikes are weighing on stock valuations, it appears that potentially even higher tax hikes would not necessarily lower valuations.

The potential for a retroactive dividend rate tax hike is that it could prompt a large number of public companies with a high concentration of family and closely held shares to declare and make a one-time, special dividend payment in the fourth quarter in order to take advantage of the 15% tax rate.

Looking back to the 2003 investor tax cuts—they were passed in May and made retroactive to the start of the year. Could a tax hike be passed by mid-2009 and made retroactive to the start of the year? And if so, could that possibility mean a lot of selling late this year to lock in the lower long-term capital gains rate? Looking back at the first year of President Clinton’s term, the tax increase was made retroactive to the start of the year after narrowly passing the Senate in August 1993, with Vice President Gore breaking the tie. However, this tax hike only affected income, not capital gains. Retroactive capital gains tax rate hikes have failed to be implemented in the past. We believe it is unlikely that a capital gains tax hike passed in 2009 will be made retroactive. If such selling does take place, it would be most likely to take place in sectors that have generated the largest long-term capital gains in recent years such as Energy and Materials. However, with few gains even on a long-term basis, this is not likely to be a significant factor. Instead, a more significant market impact that could come from the potential for a retroactive dividend rate tax hike is that it could prompt a large number of public companies with a high concentration of family and closely held shares to declare and make a one-time, special dividend payment in the fourth quarter in order to take advantage of the 15% tax rate.

Will the markets dictate the winner of the election? Historically, there is little predictability in the outcome of a presidential election based on stock market performance during the incumbent party’s term in office. Franklin D. Roosevelt was re-elected in a landslide victory in 1940 despite huge losses in the S&P 500 during his term. Harry Truman and Richard Nixon also were re-elected in the face of lackluster stock market results. Moreover, vigorous performance in the markets does not guarantee election for the incumbent party. Adlai Stevenson lost even though the market rose 75% in 1949-52 under his party’s administration, George H.W. Bush lost in 1992 even with a 57% gain in the stock market during his tenure, and despite the nearly 80% gain in the S&P 500 in the four years from 1997 through 2000, incumbent party candidate Al Gore was unable to

LPL Financial Member FINRA/SIPC

Page 6 of 8

W E E KLY MARKE T COMME N TAR Y

hold onto the White House in 2000. However, during the 90 days leading up to Election Day the stock market has predicted the winner fairly accurately. ƒ Over the past 20 presidential elections, during 11 of the 12 times the incumbent party was reelected the S&P 500 had posted a gain during the 90 days prior to Election Day. ƒ The S&P 500 posted a loss during the 90 day period 6 of 8 times when the challenger’s party was elected. A negative outlook by investors reflected in a falling stock market has tended to favor political change, while market gains have tended to benefit incumbents, indicating perhaps that investors believe the macroeconomic environment is on the right track. History tells us that market losses in the 90 days leading up to the election suggest a significant headwind for incumbent party candidate John McCain.

Will the winner of the election determine markets’ performance next year? During the year following the election the markets have demonstrated some impact from the election. Over the long term, there has been no significant stock market performance difference in the year after the presidential election based purely on which political party won the White House. Instead, the stock market has been more likely to respond to whether the incumbent political party won or lost. Reflecting back on the year after an election over the past 80 years, the stock market’s reaction has had three distinct periods. STOCK MARKET ELECTION REACTION HAS HAD THREE DIFFERENT PERIODS Bold Lines Represent Years When Incumbent Lost S&P Price Performance Market Performance Election Year After Average Return Year Election Year after Favored 1928 -11.9 1932 46.6 Challengers Challenger = 46.6% 1936 -38.6 Incumbents= -22.8% 1940 -17.9

Incumbent Party R R D D

Winning Party R D D D

1944 1948 1952 1956 1960 1964 1968 1972

30.7 10.3 -6.6 -14.3 23.1 9.1 -11.4 -17.4

D D D R R D D R

D D R R D D R R

1976 1980 1984 Year after Favored Incumbents 1988 Challenger = -6.8% 1992 Incumbents= 18.9% 1996 2000 2004

-11.5 -9.7 26.3 27.3 7.1 31.0 -13.0 3.0

R D R R R D D R

D R R R D D R R

?

?

R

?

Mixed Challenger = 1.7% Incumbents= 3.7%

2008

Source: Bloomberg, LPL Financial Past performance is no guarantee of future results

LPL Financial Member FINRA/SIPC

ƒ During the turbulent period of the 1920s, 30s, and early 40s that included the stock market crash of 1929, the Great Depression, and World War II, the stock market favored challengers over incumbents. ƒ From the mid-1940s until the early 1970s the stock market reaction to the election outcome was mixed—neither favoring nor fretting over incumbents. ƒ Over the past three decades, noted for above-average stock market returns and lengthy economic expansions, investors appear to have displayed a strong preference for incumbents This result is intuitive, since another term for the same party is likely to result in a more consistent geopolitical, legislative, and regulatory environment than a shift in the balance of power to a new administration, raising the level of uncertainty. The uncertainty can be seen, when incumbents lose, in greater risk aversion for both corporate leaders in pursuit of earnings growth and investors in the form of valuations. S&P 500 earnings-per-share growth has been positive on average during the first year of an incumbent’s term, but negative when an incumbent loses. Likewise, price-to-earnings multiples have typically expanded during the first year of an incumbent’s term and contracted when the incumbent loses. It is possible we could be entering a new era, given the weak market performance of the current decade. In the bond market, the political party of the winner of the election, rather than whether the incumbent or challenger was elected, has historically affected performance. Since the late 1920s, during the year after a presidential election the bond market has fared better under a Republican

Page 7 of 8

W E E KLY MARKE T COMME N TAR Y

2

president, with government bond returns of 6.8%, than under a Democrat, 4.3%.

S&P 500 Typically Posts a Gain During Fourth Quarter of Presidential Election Years S&P 500 Fourth Quarter Total Return During Presidential Election Years

During the past 18 Presidential election years, the S&P 500 has always posted a positive total return in the fourth quarter with only one exception, the year 2000. It would take a very powerful rally to bring the S&P 500 back into positive territory for the fourth quarter; however, a relief rally may take place amid heightened volatility as signs of healing in the credit markets combine with fading uncertainty over the elections. It is worth noting that the fourth quarter rally did not transpire until after Election Day in 1992, and in 2004 when a Labor day slump gave way to an Election day jump.

1936 1940 1944 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004

12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10%

Source: Bloomberg, LPL Financial Research

IMPORTANT DISCLOSURES Investing in international and emerging markets may entail additional risks such as currency fluctuation and political instability. Investing in small-cap stocks includes specific risks such as greater volatility and potentially less liquidity. Stock investing involves risk including loss of principal. Past performance is not a guarantee of future results. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL Financial, UVEST Financial Services Group, Inc., Mutual Service Corporation, Waterstone Financial Group, Inc., and Associated Securities Corp., each of which is a member of FINRA/SIPC. Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC Page 8 of 8 RES 1049 1108 Tracking #486563 (Exp. 11/09)