Will 'Change' Be Fulfilling This Time Around?

   Markets were surprisingly volatile today given the major news doesn't begin until Tuesday evening when election outcomes start to roll in. After Chinese manufacturing activity (PMI) was shown to have risen to its highest level in six months, stocks appeared off to the races. Shortly after the opening bell, stocks rallied in unison with the Dow rising 125 points and showing promise of closing at a new two year high above 11,205. Treasuries also opened the day displaying strong gains and it appeared as though anyone still short either market may seek to cover in advance of the week's big events to come. Provided the background of strong demand from China, crude oil also moved sharply higher.

   Unfortunately, the impressive rally could not be sustained, as a mid-morning rally in the dollar accompanied selling in both stocks and bonds. Most telling of the capitulation may have been the declines in the biggest momentum names on the Nasdaq. A brief look at the charts of Netflix (NFLX), Amazon (AMZN), Apple (AAPL) and Baidu (BIDU) over the past few days shows a steady decline, maintained today by all but Apple. After reversing the entire gains of the morning and falling 50 points on the Dow, the markets found their footing and rallied back to neutral in the last 30 minutes. In the end it was a pretty cautious day as many investors likely cemented their positions before a potentially slower day tomorrow as the waiting game begins.

   Lost in the morning rally was news that U.S. incomes actually declined in September, by 0.1%, for the first time since July 2009. The unexpected drop in incomes was accompanied by a smaller than expected increase in consumer spending during the month. An insightful blog today by Annaly Capital Management, titled Government Sponsored Spending, addresses the perplexing rise in spending relative to income. In the most troubling graph (shown below), for the first time in the postwar era, "consumption expenditures are exceeding ex-transfer income." Although this trend could continue for a while, it is far from sustainable and implies that without a commensurate rise in incomes, spending will ultimately need to retract.


 

   Tomorrow's midterm elections are expected to bring about new changes. Whether or not these changes help spur the economy, reduce unemployment and set the U.S. on a sound fiscal path for the future, only time will tell. However, what is nearly certain is that Republicans will pick up seats in both chambers of Congress, likely taking control of at least the House. Looking back a mere two years, it's remarkable to remember that an anti-Republican/George W. Bush campaign invigorated a Democratic party in a move for change and hope. Now, Republicans are riding an anti-Democratic/government campaign back into power with hopes of reverting policies back to the 'good old days.'

   The stock markets are without doubt optimistic about gridlock, arguing that in the past it has always led to meaningful returns. Just as quickly as America's forgotten its distaste for the Republic party, investors have forgotten the lost decade most recently concluded. Despite efforts to compare the election and economy today to that of 1994 and 2002, there are numerous large issues which will require action. What will come of the Bush tax cuts? Will health care or financial reform be repealed? Will government spending or entitlements be cut? One way or another, these questions and others will be answered, bringing about a new set of policy changes. However, if we are so abruptly unhappy with the desired changes of the '08 election, how can changes desired in 2010 inspire such certainty that they will prove any more fulfilling?

   John Mauldin's article today, Be Careful What You Wish For - Thoughts From The Frontline - InvestorsInsight.com | Financial Intelligence, Advice & Research / Investment Strategies & Planning for Individual Investors., further articulates this view of caution. Although Mauldin highlights a number of worthy points, I'd like to focus on one that has not received significant attention from the general media. Mauldin discusses the potential expiration of extended unemployment benefits on November 30th. Based on his calculations, somewhere around one million Americans could lose unemployment benefits by year's end, with another three to four million being dropped by April. Assuming Republicans gain control of at least the House, is it unreasonable to think these benefits may be left to expire? Even if they are ultimately renewed, it seems easy to imagine any decision being held up for some time during the lame duck session. Considering the graph shown earlier related to spending and income, the sudden reduction in billions of dollars of transfer income would certainly be a drag on consumer spending. Given the U.S. economy still relies heavily on consumer spending, this decision alone could reduce expected GDP growth for several quarters.


  With the election results still unknown, I'll end with a troubling question for the future. The Republicans have seemingly spent the past two years attempting to block most measures proposed by the Democrats. With the economy still struggling they are now poised for significant gains. Let's imagine that the Republicans take the House but Democrats maintain a small advantage in the Senate. Would Republicans grind Congress into a stalemate, pressuring the economy and unemployment, all in hopes of riding the frustration to sweeping control of the White House and Congress in 2012? (Even more concerning...would this move actually be intelligent political strategy?)