LP L FINANCIAL R E S E AR C H
Weekly Market Commentary
v4
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 filibuster-
proof 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.
November 3, 2008
Election 2008
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
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 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.

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 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

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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.
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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.
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:
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 W E E KLY MARKE T COMME N TAR Y

ƒ Initial details of the 2003 investor tax cuts began to appear in early
1 High Dividend Paying Stocks Underperformed
when Dividend Tax Cut Passed December of 2002 with a statement from President Bush providing
Performance of the Top 20% and Bottom 20% of further insight into the package of tax cuts on January 7, 2003. Stocks
Stocks in Russell 1000 Index by Dividend Yield slumped in December and January—even around the days details came
to light—as investors were focused on the impending invasion of Iraq. The
High Dividend Payers performance of both non-dividend paying and dividend paying stocks were
Low Dividend Payers
70% very similar, despite the prospects for a cut in the dividend tax rate.
60% ƒ Attention returned to the tax cuts in April 2003 as competing bills with
50%
various provisions moved through both houses of Congress. There was
much uncertainty as to what the final tax cut elements were to be and
40%
whether any investor tax cuts were going to be passed. The tax bill
30%
narrowly passed in mid-May with the Vice-President Cheney breaking
20% the tie in the Senate. The package including the investor tax cuts was
10% signed by the President on May 28, 2003. In April and May (and over
0%
the rest of the year), the stocks of low or no dividend paying companies
Apr May Jun Jul Aug Sep Oct Nov Dec outperformed high dividend payers as stocks rallied powerfully and the
03 03 03 03 03 03 03 03 03 invasion of Iraq got underway.
Source: Factset, LPL Financial Research
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.
Looking at the post-WWII
In theory, stocks are valued by investors based on expected total return net
relationship between investor of applicable taxes. For example, if dividend and capital gains taxes were
tax rates and stock market 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
valuations based on trailing total return on the stock market the investor keeps on an after-tax basis and,
price-to-earnings ratios, we therefore, the more the investor would value the stocks. Looking at the post-
WWII relationship between investor tax rates and stock market valuations
can see that stocks may have based on trailing price-to-earnings ratios, we can see that stocks may have
already priced in a return to higher investor tax rates.
already priced in a return to
John McCain has indicated he would seek to maintain the investor tax cuts
higher investor tax rates. 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,

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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.
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.
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W E E KLY MARKE T COMME N TAR Y
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.
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
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 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 ƒ During the turbulent period of the 1920s, 30s, and early 40s that included
THREE DIFFERENT PERIODS the stock market crash of 1929, the Great Depression, and World War II,
Bold Lines Represent Years When Incumbent Lost the stock market favored challengers over incumbents.
S&P Price ƒ From the mid-1940s until the early 1970s the stock market reaction
Performance
Market Performance Election Year After Incumbent Winning to the election outcome was mixed—neither favoring nor fretting
Average Return Year Election Party Party over incumbents.
Year after Favored 1928 -11.9 R R
Challengers 1932 46.6 R D ƒ Over the past three decades, noted for above-average stock market
Challenger = 46.6% 1936 -38.6 D D returns and lengthy economic expansions, investors appear to have
Incumbents= -22.8% 1940 -17.9 D D
displayed a strong preference for incumbents
1944 30.7 D D
1948 10.3 D D This result is intuitive, since another term for the same party is likely to result
1952 -6.6 D R in a more consistent geopolitical, legislative, and regulatory environment
Mixed
1956 -14.3 R R
Challenger = 1.7% than a shift in the balance of power to a new administration, raising the
1960 23.1 R D
Incumbents= 3.7% level of uncertainty. The uncertainty can be seen, when incumbents lose, in
1964 9.1 D D
1968 -11.4 D R greater risk aversion for both corporate leaders in pursuit of earnings growth
1972 -17.4 R R and investors in the form of valuations. S&P 500 earnings-per-share growth
1976 -11.5 R D has been positive on average during the first year of an incumbent’s term,
1980 -9.7 D R but negative when an incumbent loses. Likewise, price-to-earnings multiples
Year after 1984 26.3 R R
Favored Incumbents 1988 27.3 R R have typically expanded during the first year of an incumbent’s term and
Challenger = -6.8% 1992 7.1 R D contracted when the incumbent loses. It is possible we could be entering a
Incumbents= 18.9% 1996 31.0 D D new era, given the weak market performance of the current decade.
2000 -13.0 D R
2004 3.0 R R In the bond market, the political party of the winner of the election, rather
? 2008 ? R ? than whether the incumbent or challenger was elected, has historically
Source: Bloomberg, LPL Financial affected performance. Since the late 1920s, during the year after a
Past performance is no guarantee of future results presidential election the bond market has fared better under a Republican

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 W E E KLY MARKE T COMME N TAR Y

2 S&P 500 Typically Posts a Gain During Fourth president, with government bond returns of 6.8%, than under a
Quarter of Presidential Election Years Democrat, 4.3%.
S&P 500 Fourth Quarter Total Return During During the past 18 Presidential election years, the S&P 500 has always
Presidential Election Years posted a positive total return in the fourth quarter with only one exception,
12% the year 2000. It would take a very powerful rally to bring the S&P 500 back
10%
8%
into positive territory for the fourth quarter; however, a relief rally may take
6% place amid heightened volatility as signs of healing in the credit markets
4% combine with fading uncertainty over the elections. It is worth noting that
2%
0%
the fourth quarter rally did not transpire until after Election Day in 1992, and
-2% in 2004 when a Labor day slump gave way to an Election day jump.
-4%
-6%
-8%
-10%
1936
1940
1944
1948
1952
1956
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004

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.

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