Politics & Policy

Better to Be Bearish

(Google Finance)
Romney would benefit from a market apprehensive about the election.

Is this the Romney-Ryan rally? Since Mitt Romney picked Paul Ryan to be his running mate, the stock market has moved to highs not seen since George W. Bush was still president. Indeed, when dividends are included, U.S. stocks are at an all-time high.

Consider where this rally began. Stocks fell sharply this spring as hoped-for economic growth failed to materialize. The macroeconomic data hasn’t improved, yet stocks turned around nevertheless on a day freighted with political significance. The bottom was on June 4, and the launch toward new highs began the next day, when voters in Wisconsin rejected the union-funded campaign to unseat Republican governor Scott Walker — in a landslide.

This ringing endorsement of fiscal conservatism and limited government in a decidedly purple state has signaled to forward-looking investors that they can hope for an end to the growth-killing “tax, regulate, and spend” doctrine of the Obama presidency. Now a confirming signal of hope has come — Romney’s selection of Walker’s fellow Wisconsinite and fellow fiscal conservative Paul Ryan.

Hope, to be sure — but risk as well. With its unending attacks on Romney’s involvement with Bain Capital, the Obama campaign had already made this election a referendum on capitalism. Now, with Ryan on the ticket, Obama has made it more specifically a referendum on the limitless welfare state. The stakes are enormous.

The stock market is right to celebrate the birth of a presidential campaign in which such consequential issues will be frankly discussed rather than studiously ignored. It is right to celebrate the morning in America that could dawn if the Romney-Ryan ticket wins. But the stock market may not be taking sufficiently into account what would happen if Obama won.

It would take mere weeks for the American people to find out what he was capable of with his last election behind him and a perceived mandate to expand the welfare state. By year’s end, Obama could shove the United States economy headlong off the “fiscal cliff.”

In the lame-duck session of Congress, the GOP will insist that today’s low tax rates be extended for everyone, as they did in 2010, the last time the rates were slated to expire. Obama will insist that they not be extended for top earners, families with household income above $250,000. If the two sides deadlock, tax rates will automatically rise across the board, erasing more than 4 percent of disposable personal income from the economy, immediately throwing the United States into sharp recession.

It’s a game of chicken, and there’s no assurance that cooler heads will prevail. The GOP, feeling it has little to lose at that point, will refuse to be complicit in Obama’s tax-the-rich class warfare. If Obama won reelection, he would be a lame duck with a mandate and a great deal of confidence that he could blame the deadlock on GOP intransigence — and then look like a hero by proposing another gigantic stimulus program to get the economy out of the recession he’d caused.

But the stakes will be even greater than that. At some point within months after the election, the statutory debt limit will have to be raised again. The Republican-controlled House of Representatives barely permitted the limit to be raised a year ago, and the ensuing political chaos resulted in Standard and Poor’s downgrading the credit rating of the United States Treasury. If Obama won the November election and refused to compromise on taxes, surely the GOP, which will likely control the House, wouldn’t compromise on borrowing. So to a recession at the onset of Obama’s second term add a government shutdown and a debt default.

On the other hand, if Romney wins, these problems simply vanish. Even if we fall off the fiscal cliff at year’s end, President Romney, with the help of a GOP-controlled Congress, can easily set it right when he is inaugurated on January 20.

In the intermediate term, if Romney wins, Obamacare can be repealed, liberating the health-care sector, one of the largest and most innovative sectors of the economy. Dodd-Frank can be replaced, removing from the critical financial sector the threat of limitless and indeterminate regulation. More broadly, the entire private sector can stand up again, rising from the defensive crouch it has had to assume during four years of crippling uncertainty about taxation and regulation.

In the longer term, Romney and Ryan can begin the difficult work of repairing the unsustainable trajectory of the bloated welfare state.

Clearly, it is those happy outcomes that the stock market is expecting now. But there is some chance that this very expectation carries the seeds of its own undoing.

It is an iron law of politics that confidence in the economy reelects incumbent presidents. The classic econometric work on this axiom is that of Yale’s Ray Fair, whose widely followed model is now calling the election a toss-up, with Romney as the ever-so-slight favorite.

That means that the direction of the stock market — and its effect on economic confidence — could be the swing factor in this election. If stocks continue to climb, confidence in the economy will climb too, and Obama could win. On the other hand, a falling stock market will poison confidence, and Romney will win.

So we are faced with a paradox, a version of George Soros’s “theory of reflexivity,” according to which financial markets affect events in the real world, which in turn affect the financial markets. A stock market that rises because it expects Romney to win might very well cause Obama to win — and make stocks fall. But if stocks fall because the market expects Obama to win, then Romney will win — and that will make stocks rise.

What’s an investor to hope for — a stock-market crash? Perhaps, but happily the best outcome is the most likely one — a polarizing, down-and-dirty, rock-’em-sock-’em campaign that maximizes uncertainty and keeps the economy and the stock market on tenterhooks from now till November. That would require the Romney-Ryan rally to wind down soon, at least for now. But if that uncertainty elects the Romney-Ryan ticket, then the sky becomes the limit.

— Donald L. Luskin, chief investment officer of TrendMacro, is the co-author of I Am John Galt: Today’s Heroic Innovators Building the World and the Villainous Parasites Destroying It.

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