Markets Commentary — Special Edition

David Joy — Chief Market Strategist, RiverSource Investments

A summary and historical perspective on the election and what it may mean for investors

November 5, 2008

In the months leading up to yesterday's election, the two presidential candidates proposed very different tax structures as part of their campaigns. The following is a brief comparison of the major provisions of each plan that was suggested heading into the election, along with more detailed changes proposed by president-elect Sen. Barack Obama. I have also included some historical data regarding the effects of previous administrative changes to the tax code in order to provide a glimpse of how the markets may react to this new administration.

Summary of proposed tax changes from the two candidates leading up to the election

	Sen. John McCain	Sen. Barack Obama
Income Taxes	Retain current rates, as reduced in 2001 — 2003	Maintain the current 10, 15, 25 and 28% rates, as reduced in 2001 — 2003; allow the reduction of top two brackets to expire, raising them to 36% from 33% and 39.6% from 35%; eliminate taxes on seniors making less than $50,000
Capital Gains and Dividends	Maintain the current 15% rate	Raise to 20% for couples earning more than $250,000
Corporate Income Tax	Cut to 25% from current 35%, phase-in by 2015	Eliminate capital gains taxes on start-up and small businesses; close “inefficient loopholes”
Estate Tax	15% on estates over $5M and $10M for married couples	45% on estates over $3.5M and $7M for married couples
Social Security	Retain current 12.4% tax on wages up to $102,000; supplement with personal accounts	Retain current 12.4% tax on wages up to $102,000; add 4% to wages above $250,000 effective 2018
Alternative Minimum Tax (AMT)	Phase out	Extend current patch

Beyond these primary items, president-elect Obama has proposed additional tax changes in several specific categories.

These proposed changes include:

• Creating income-related subsidies for health insurance expenses — pay or play for employers
• Creating a refundable credit of 6.2% of up to $8,100 of wages
• Creating a refundable credit of 10% of mortgage interest for non-itemizers
• Extending childless-earned income credit
• Increasing earned income credit for families with three or more children and married filers
• Increasing and adjusting child and dependent care credits
• Adjusting savers credit and making it refundable
• Making permanent R&D and renewable energy production credits
• Mandating automatic 401(k)s and Individual Retirement Accounts (IRAs)
• Increasing HOPE credit and matching rate to 100% up to $4,000
• Restoring phase-out personal exemptions and itemized deductions for couples earning above $250,000 and singles earning above $200,000
• Creating a refundable tax credit for higher education expenses up to $4,000
• Suspend mandatory distribution rules for IRAs and 401(k)s at age 70½
• Increasing small business expensing limit to $250,000
• Eliminating tax on unemployment benefits in 2008 and 2009
• Eliminating tax on hardship withdrawals from IRAs and 401(k)s

Sources: The Tax Foundation, a non-partisan tax research group based in Washington, D.C.; International Strategy and Investment (ISI), Tax Policy Center-Urban Institute and Brookings Institution

An historical look at the effect of changes in the capital gains tax rate on the Dow Jones Industrial Average (DJIA)

The capital gains tax rate has been changed 18 times dating back to 1913. Thirteen of those changes involved increases in the rate, while five entailed cuts. The effective date of the enabling legislation has important implications for the performance of equity markets and the effect of the change on revenue generation.

Typically, changes to income and dividend taxes become effective retroactively to Jan. 1 of the year in which the legislation is passed, or to Jan. 1 of the following year. The effective date of capital gains tax changes has historically been different. Of the last five changes, four were cuts in the rate and one was an increase. In each of the four rate cuts, the effective date of the change was established to be retroactive to a date before the actual passage of the legislation. In the case of the one increase, in 1986, the effective date was established effective January 1987. In that instance, the revenue generated from an acceleration in the realization of capital gains tax revenue soared in 1986, almost doubling. Clearly, the intent of rate reductions is to encourage investment, while the intent of increases is to generate revenue.

The performance of the DJIA has been markedly different in the years following capital gains tax rate changes. The median performance in the thirteen years following legislated increases has been 6.1%, with 11 years of gains and two years of declines.

Year	DJIA performance
1913	-10.3%
1922	21.7%
1934	4.1%
1942	7.6%
1968	4.3%
1969	-15.2%
1970	4.8%
1971	6.1%
1972	14.6%
1976	17.9%
1987	2.3%
1991	20.3%
1993	13.7%

The median performance of the DJIA in the five years following capital gains rate cuts has been 22.6%, with four up years and only one down year.

Year	DJIA performance
1938	28.1%
1979	4.2%
1981	-9.2%
1997	22.6%
2003	25.3%

Source: Ned Davis Research

Additional observations regarding changes in the White House and Dow performance

The performance of the DJIA has also been markedly different both before and after elections that have resulted in changes in the White House. In the 10 instances when Republicans won, the index rallied between the time of the second nominating convention and the election, rising by a median of 5.7%. Following the election, the DJIA went on to post a median return of 4.5% through year end. During the first half of the subsequent calendar year, the index posted a median gain of 9.5% and a second-half gain of 5.8%.

In the five instances of Democratic victories, the market fell 1.3% between the second convention and the election. From the election through year end, the DJIA rose by a median of 1.2%. During the first half of the following year it gained 6.5% and in the second half it gained 5.2%.

	Second convention through election	Election through year end	January through June of following year	July through December of following year
All election years	2.5%	2.1%	0.9%	4.3%
Republican win	5.7%	4.5%	9.5%	5.8%
Democratic win	-1.3%	1.2%	6.5%	5.2%
All years	NA	NA	4.0%	4.8%

Source: Ned Davis Research

According to Citi Investment Research, neither party has been “bad for equity investors.” The best combination for stocks of executive and legislative branch control throughout an administration has historically been a democratic president and a republican Congress, with a 17% return. The worst has resulted from democratic control of both, with a return of 8%. When republicans control both, the average return has been 13%, and when there is a republican president and a democratic Congress, the return has averaged 12%.

Interestingly, research from our own chief economist, Dan Laufenberg, suggests that comparing the average performances of the stock market over time under different combinations of republican and democratic control of the legislative and executive branches may actually be a bit misleading. Based on his research, he is more inclined to believe that differences in these averages tended to be driven by a few outliers and were most likely caused by exogenous factors totally independent of which political party was in power at the time.

Potential investment implications of administration change

Taking Dan's perspective into consideration, a new administration will still result in numerous implications for various industries and investment sectors. The healthcare and energy sectors are possibly the most affected by the pending change in Washington. Concerning healthcare, under an Obama administration it appears there will be an effort to restrict prescription drug prices, thus pressuring the pharmaceuticals. His administration might also pose risks for the managed care industry — depending on what changes are made to the delivery and cost structure of healthcare. Pharmacy benefit managers will likely see positive impacts.

Concerning energy, an effort to reduce greenhouse gas emissions is likely but the details will dictate winners and losers. Alternative energy sources were likely to be winners regardless of who won the election. In Obama's administration he is generally supportive of ethanol but less so of nuclear, while the coal industry will likely be at risk under his leadership.

The industrial sector could benefit from increased fiscal stimulus for infrastructure projects under an Obama administration, while higher taxes could hurt luxury retailers. Another obvious beneficiary of higher marginal income taxes under an Obama administration are tax-free municipal bonds already attractively valued, as their tax-equivalent yields would only increase. Lastly, since the tax differential between capital gains and dividends is quite likely to be maintained under the incoming administration (currently no differential), then neither dividend nor non-dividend paying stocks are likely to derive any relative benefit from the upcoming change.