Investment professionals rely on a variety of fundamental factors to advocate investment strategies for long-term investors. The underpinnings for a positive outlook in today’s markets are strong corporate profits, productivity advances, low inflation, and low interest rates. An evaluation of these variables suggests that U.S. stocks are undervalued by some 15 to 25 percent, or more. On this basis, the U.S. stock market has been soaring to new highs, and although the “sell in May and go away” adage is currently dominating media attention, the stock market rally continues to imply a better economy for the balance of this year.

While long-term stock returns are impressive relative to other investments, interim stock returns can make or break an investment strategy. For the 11 years ending in 1980, the Dow Jones Industrial Average was essentially unchanged. Then, from 1992 through 1999, the Dow tripled in value. The divergent trends in these returns challenge the presumption that double-digit long-term returns are a sure bet for long-term investors.

Looking back, this divergence is best explained by the economic policies that influenced growth and inflation. In 1971, Richard Nixon raised tax rates substantially, imposed wage and price controls, and took the U.S. off the gold standard. By 1974, the Dow had plunged from over 1,000 in 1969 to a low of 575. Nixon’s floating of the dollar and the subsequent explosion in the global supply of dollars contributed to the first surge in oil prices, driving U.S. inflation into the double digits and undermining corporate profitability and consumer confidence. Meanwhile, Federal Reserve policy was erratic, as officials tried to control growth in the money supply by varying the fed funds rate.

When Ronald Reagan took office in 1981, the U.S. economy was experiencing record-high interest rates (I recall that my car loan was 21 percent) and long-term government bond yields reached 16 percent. However, when Reagan pushed through two large tax-rate cuts and the Fed, under Paul Volcker, tightened monetary policy, financial markets revived and stock markets boomed. The Dow climbed from 850 in 1980 to over 2,000 when Reagan left office in 1988.

Of course, even when economic policies are favorable to markets, markets can suffer from the random event. The stock market crash of October 1987 was not caused by economic policy or financial conditions. Rather, the illiquidity created by the portfolio insurance scheme (and related program-trading) caused the market to malfunction. This led to dramatic, although short-term, price declines. Once regulators resolved the problem, the market moved higher.

Then, in the 1990s, stock prices tripled. This was attributable to the successful shift in monetary policy to a price rule and a related decline in interest rates and inflation. In 1994, few market observers had yet caught on to the coming surge in equity prices. I remember at least one prominent mutual fund economist, as well as a plethora of perennial bears, who saw little upside in the stock market at the time. But Fed chairman Alan Greenspan’s commitment to stable interest rates contributed to increased confidence in the financial markets, and in time this stability fostered a record run in stock prices.

One should also give credit to the evolving technology boom and the Internet gold mine, although this boost was temporary.

The stock market crash of 2000-03 was driven by the Y2K phenomenon, even though, ironically, Y2K was uneventful. Computers that were supposed to be exposed to a computer meltdown when the new millennium began were able to handle the transition without a glitch. However, the planning and enormous spending for Y2K caused an economic distortion; technology spending was shifted into 1998 and 1999. At the beginning of 2000, few analysts detected this distortion, and instead looked to the successful avoidance of a computer-based catastrophe as a reason to be bullish. It wasn’t until technology spending began to decline, and many Internet companies started to go belly up, that equity markets embarked on their descent.

Fortunately, the implementation of two tax rate cuts under President Bush in the middle of this economic downturn staved off a pending recession and reversed the decline in stock prices. By early 2003, the expectations of a second major tax-rate cut put the market back on track. The subsequent economic recovery surprised most pundits and pushed nearly all measures of economic well-being to new highs.

Of course, the current stock market advance is supported by surprisingly strong corporate profits. However, these profits emanate from government policies that were designed to promote free-market capitalism and stimulate the economy.

Now that the Fed is maintaining a neutral monetary policy and government spending has fallen below expectations, economic growth may shift into low gear. Using best practices as our guide, once those profits begin to decelerate, economic policy should become stimulative — i.e., an easier monetary policy, increased government deficits, and stable if not lower tax rates. The problem is, the great majority of Democrats in Washington plan to let the Bush tax cuts expire, which would be the equivalent of a substantial tax-rate increase. The editorial page of the Wall Street Journal recently put the size of that tax increase at $650 billion.

So, the U.S. financial markets face two big problems today: political reversion and global capitalism. Global capitalists are challenging the U.S. and competing in world markets at an ever increasing rate. This would be a promising development if U.S. companies could count on the help and support of the government in this competitive environment. But politicians seem more likely to undermine corporate leadership and raise taxes at every turn. The inevitable outcome of this political harassment will be a loss of business and profitability for companies that rely heavily on U.S.-based sales and production.

Such a wave of Democratic tax-rate increases (again, to the tune of hundreds of billions of dollars) would hit financial markets like 1971 all over again. But the markets will wait for a downturn in earnings before declining, just like they did with Y2K (logically, the market turning point was January 1, 2000).

This time around, an evaluation of at least one wave of tax-rate increases — whether on oil company profits or hedge-fund capital gains, or by way of the expiration of the Bush tax cuts — will give investors the opportunity to view the coming stock market decline like an auto crash in slow motion. Current Democratic proposals to raise taxes are the equivalent of the ones imposed by President Nixon, and if those proposals come to fruition, the second decade of the 21st century may look just like the 1970s — with one caveat. Many foreign politicians have learned from their mistakes; they now know that socialist, redistributionist policies are economy killers. But since too many American politicians have not yet learned this lesson, our economy and financial markets will be stuck fighting bad policy from within, and supercharged competition from without.