Proving Grounds: Four Horsemen of the Economy
By J. Taylor Brown

We are in the midst of what may prove to be one of the most important presidential elections in a generation. There are real issues looming for the leadership of this country; issues that transcend typical quadrennial election matters. The War on Terror, Iraq, the housing and credit crises, decay of our once great infrastructure, our shamefully expensive, yet inefficient healthcare system are but a few of the concerns that are coming to a head in the relatively near-term whether the new president likes it or not. Each must be dealt with tout de suite. But the paramount topic, the one that will cascade throughout the entire globe is: What is to become of the great American economy?

The engine that has fueled the globe since the Second World War is in dire need of an overhaul. In fact, by almost any metric, it is leaking oil and it is going to take more that a simple tune-up to fix it. It is getting to the point that the United States’ credit rating is in jeopardy and is potentially at risk of losing its AAA rating. The iron-clad greenback is fast losing its status as preferred currency; a title that it has held for generations.

The next president is going to have to deal with the economic mess first and foremost. As the general election draws near, it is apt to worsen. There will be considerable pressure from both the electorate and the media to have the candidates in earnest explain their economic policies. The candidate that succeeds on this front will most likely win the presidency. Having a good idea about who is likely to win the general election is an important element to our investment strategy as we move deeper into the election cycle.

Discussion about the economy has been strikingly absent from both the democrats and the republicans. The main reason is that quite frankly, the economic situation in this country is a bummer.

Senator McCain (R-AZ), the republican nominee, has glazed over the specifics of his economic policies. In many regards, Mr. McCain is a “change” candidate on a whole litany issues, but
he is “stay the course” fiscally. This may prove to be lethal if the economy is still beleaguered in a few months. But if the current policies foster a rebound in a quarter or so as some economists are forecasting, he could most definitely be the beneficiary on Election Day.

At this juncture, the democratic nominee is a toss-up. Thus far, both candidates on the left have been disturbingly nonchalant about the economic condition in the U.S. While they are quick to point out that they consider current administration policies to be a failure, Bush bashing does little to clarify what they would do differently. According to their websites and campaign literature, they both have comprehensive far flung plans to help most Americans. Both Senator Clinton (DNY) and Senator Obama (D-IL) favor a repealing of the Bush tax cuts and a reassessment of domestic trade policy.

They both have a litany of lofty ideas on how they would make the U.S. economy better. Green collar jobs, strengthening the middle class, comprehensive government reform, changing the tax codes, are some of the abstract policies both tout. In short, they are both change candidates on this issue. Neither has been all that impressive or persuasive on this front. A heated debate on healthcare may garner votes from their base, but as we move from primary season to the general election look for this to change. If the economy continues to sour, the democratic nominee will have an advantage on this subject and a rebound in the economy would be a huge negative for them.

Change is in the air. Both parties have realized that there is a general outcry for change. Many, quite possibly the majority of Americans, are unhappy with the status quo. It has been a prosperous two and a half decades and no one wants to regress back to the not-so-super seventies.

There is no shortage of dire predictions for the near term in the United States.

There are also many well respected economists whose conclusions are not nearly as ominous. This is the fundamental debate that the candidates must have. Either current policy is sufficient with a tweak here and there, or economic policy must be revamped. Mr. McCain would be perceived as a defender of the status quo, and the democratic nominee would supposedly offer their new vision.

It is our contention that the economy will go a long way to determining who the president will be. We have devised a simple methodology on gauging the economy in the eyes of voters: The Four Horsemen of the Economy. Individually they indicate how different groups of voters perceive the strength of the U.S. economy; collectively they may very well decide the election.

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The Dow

While even the most ardent Dow theorist would confess, the index is not without its limitations. The S&P is far broader and thanks to constant rebalancing reflects current trends. The NASDAQ is a much better indicator of innovation and growth. But, as far as a barometer for gauging the health of corporate America, the Dow is nonpareil. When the Dow is doing well, America is doing well; when the Dow is in a funk, it not only ripples throughout Wall Street, but Main Street as well. The biggest impact is felt by investors, generally members of the upper-middle class and above; those with 401Ks, bonuses, mutual funds and/or investment portfolios.

An incumbent can rely on these voters more readily when the Dow is strong. Currently, the January lows have been breached and the Dow is at the official Ned Davis Research bear market level of a 13% decline after 145 calendar days. The Dow is now about 16% off its high, but has not completely broken down. Once again under significant pressure, the blue-chip benchmark has wavered, but not yet imploded.

It is safe to assume that voters most attuned to the Dow are in favor of the extension of the Bush Tax policy; a signficant plank in Mr. McCain’s platform. The Street inherently hates change, the mantra of the democrats. So if the Dow holds up through Election Day, voters on The Street will probably break for the right. Conversely, a continued slide or a meltdown
close to the first Tuesday in November could sway some of these voters left.

Consumer Confidence

Note that this element of the four horsemen changed from the initial analysis in November. In that issue I used gold as a proxy for the consumers roll in the equation. Gold has historically been a harbinger and a hedge against a weakening dollar. This go around we used the Conference Board’s Consumer Confidence number to illustrate the same fear that high gold prices also confirm.

The Consumer Confidence number is essentially a proxy for the middle class’s belief in the economy. The middle class in this country has been squeezed for the better part of the last two decades. While they have party allegiances, historically they can be swayed by the thickness of their wallets. Clinton and Obama know they need the middle class in order to
win the nomination, so look for the battle for the middle class to pick up steam in the near term.

The U.S. consumer is fatigued. There is a burst of stimulus in the pipeline, but currently, John and Jane consumer are beginning to tighten their belts. It is not that they don’t want to spend; rather, they are simply tapped out. The Conference Board Index of consumer confidence dates back to 1967 spanning the last 10 presidential elections. As the second chart down illustrates, three times consumer confidence has been in a cascading decline within close proximity of a general election. In 1980, 1992 and 2000 the incumbent party lost power.

Current readings of consumer confidence are bleak with no rebound in sight. If the current trend holds, democrats would be in good shape on this front. But it is important to note that a
sharp rebound would undoubtedly favor republicans. Consumer confidence is all about perception and expectations. It is a referendum on the economy of Main Street akin to right track/wrong track polls and can turn on a dime.

Inflation

Inflation hits American small to midsized business owner hardest. Generally upper-middle to lower upper, the small business owner is the backbone of this country; they hold tremendous sway politically. Small business employs tens of millions of Americans. If small businesses are not doing well, it spills over to huge swaths of the populace. Voters have always rejected high inflation. There have been four instances of significantly elevated inflation in election years since 1952, and in each instance, the incumbent party lost the White House, 1952, 1976, 1980 and 1992.

Inflation is weighing on Americans, but according to the Federal Reserve, inflation expectations remain anchored and inflation at large is contained. But the proof is in the pudding. Higher
oil and natural gas prices are slowly seeping into the Producer Price Index (PPI) and the Consumer Price Index (CPI). We are approaching an important threshold in the CPI of 5%; PPI has already reached that level. If this trend continues, these pivotal voters may spearhead a change of party. However, if the Fed decides to actively address the inflation situation, and manages to curb its rise, small businesses may be spared much pain. This could be a boon for McCain and a serious problem for democrats.

Unemployment

Unemployment can be the ultimate arbitrator of who wins in November. The middle class down to the lower class are the ones most at risk of losing their jobs in times of economic turmoil. Moreover, in times of serious economic instability, unemployment seeps all the way to upper management. If the jobs situation in this country unravels, a change of
party is all but assured.

As the chart shown illustrates, rising joblessness lead to incumbent losses in 1960, 1976 1980 and 1992. But it is not simply the absolute level that is of importance with respect to the unemployment numbers. The trend of increasing or decreasing number of Americans working is what matters most.

1984 is a perfect example. While joblessness was high entering Reagan’s reelection bid, the rate was sharply decreasing. Thus the perception was that things were getting better. In 1976, unemployment was a major contributor to the republican’s defeat. The same can be said of Bush 41’s bid for a second term in 1992. The unemployment rate is climbing higher, but we are far from crisis levels.

As it stands, though diminishing, jobs are available. If this ceases to be the case, the democrats may cruise to victory.

Recession

We are currently, in all likelihood in a recession. The shaded gray on the accompanying charts indicate the recessionary periods over the past 60 years. Over the last 60 years, the economy has been in a recession in an election year only twice, 1960 and 1992. Both times, the incumbent party lost the White House.

If the recession is deep, Mr. McCain faces a daunting task. However, a recovery in the third quarter could be a boon politically. He can rightly point to fact that the economy is at a fragile juncture and that current policy is working. Don’t rock the boat! The only problem is Q3 GDP will not be known until the last day of October leaving three days until Election Day.

The economy has not endured a significant recession since 1981. Most Americans in their prime earning years of 24 to 54 have little or no recollection of what a recession is. After all, to put that into perspective, a 24 year old was not born the last time we had a significant recession, and a 54 year old was a youngster of 27 the last time the economy was truly in the tank. A deep recession may be met with outrage; and the incumbent party will most likely bare the brunt of the backlash. Only time will tell, but unless the economy rebounds quickly, change is likely to occur.

While a substantive debate on healthcare can win a primary election, when it comes to the general election it’s most definitely the economy, stupid. All three major candidates are qualified and competent. There will be ups and downs in the market as stocks will do what they always do, fluctuate. Whoever wins will shape the economy as they see fit. Knowing in advance who may win will give an investor a major leg-up. When the democratic nominee is finally determined, and meaningful debate about the economy finally begins, we will turn our
attention to dissecting the candidate’s proposals. There are going to be significant investment opportunities.