Election 2008—Impact on Wall Street
and Main Street

        August, 2008 - Although the headlines have lately been dominated by the slowing economy, the 2008 elections are poised to regain center stage as we approach the Democratic and Republican conventions. While there will no doubt be hours of coverage and entertainment value, we’re taking this opportunity to focus on what the election means for investors.

Who will be elected president?

       According to recent polls, the Democratic candidate Barack Obama has a slight lead in the popular vote over
the Republican candidate, John McCain. However if you analyze the Electoral College votes, (see website
realclearpolitics.com) Obama’s lead is much more substantial with large electoral vote states such as California,
Illinois and New York probably going Democratic. This adds up to 153 votes fairly certain with another 85 votes from states that are leaning Democratic for a total of 238 out of the 270 needed to win the presidency. Odds would seem to indicate that Obama will be our next President.

How does the market perform when an incumbent party loses the White House?

        This chart (Figure 1) shows the historic impact of past elections on the Dow Jones Industrials from 1900 -2004 — Presidents McKinley through George W. Bush. Over each four year election cycle, the data shows the percentage change in the Dow on a year-to-year basis, i.e. January of the first year of the cycle versus January in the second year of the cycle, etc. The strongest Dow performance comes when the incumbent party wins. The next best performance occurs when the Republican Party wins. The worst performance is when the incumbent party loses. The gray line charts the Dow’s movements for all elections. Generally the market seems to perform better when an incumbent party is reelected, probably in part due to less uncertainty about future policies. (See graph below)

Will the Democratic majority increase in the House and Senate?

        Several Republican Senators are retiring which puts their seats up for grabs. Democratic voters seem more energized this year which could favor Democratic candidates. Pundits are predicting that the Democrats could pick up 20 or more House seats and three Senate seats. However, Democrats will probably not achieve a 66% majority (in either the House or Senate) which could vote down filibusters or other stalling tactics by the Republicans, so bipartisan support will still be important to pass major legislation.

Will this impact my taxes?

        There are several tax deductions/credits that are set to expire after 2008—the individual sales tax deduction, the tuition tax deduction and the corporate research and development tax credit. In addition, barring any action
by Congress, the Bush tax cuts will expire in 2010 and revert to the levels shown in Table 1 below. Among the most
important are the cap on individual rates and preferential treatment for dividends and long-term capital gains.
The estate tax exemption which rises to $3.5 million in 2010 would also drop to $1 million in subsequent years.
Let’s examine some of the proposals put forth so far on Obama’s platform:
• Keep the Bush tax cuts for families making less than $150,000. This means the status quo for taxpayers in
this income bracket.
• Increase the long-term capital gains rate to 20–28% which would favor taking gains this year and enjoying the
lower tax rate.
• Remove the cap on wages subject to the social security tax. This would be especially onerous on the self-
employed who pay “double”—the employers and employees tax.
• There has been no mention of maintaining the lower tax rate on qualified dividends which would make dividend
paying stocks somewhat less attractive.
• McCain would like to make the Bush tax cuts permanent but this will be very difficult given the recent announcement by the White House Budget office that the budget deficit will probably balloon to a record $482 billion. Any tax cut discussions will be challenging with the increased need to offset lost revenues to manage the budget deficit.



What about a permanent fix for AMT?

        In recent years, Congress has passed an annual bill providing a temporary adjustment for the AMT (alternative
minimum tax). The original AMT bill was not indexed to inflation, so each year many more middle class taxpayers are potentially subject to this tax. Generally the annual legislative fix focuses on keeping the number of taxpayers
impacted by AMT relatively fixed at around 4 million. Without the annual patch, this number could jump to 20 million. It is likely that a temporary fix will again be passed this year but a permanent solution will be more difficult.

What investments are appropriate if tax rates rise?

        Buy and hold strategies that are less likely to generate significant capital gains (especially of the short-term variety) and municipal bonds that are exempt from federal income taxes (and in certain cases, state taxes) are the most obvious ways to keep the tax man at bay. If the tax rate on dividends reverts back to the individual ordinary tax rate, then higher-yielding, dividend-paying stocks will be a less attractive option for generating income in taxable accounts.

How are the Morningstar Managed Portfolios positioned?

        As part of the Managed Portfolios process, we devote a lot of time to determining the optimal asset allocation to
meet certain risk and return objectives over an appropriate time period. We then seek out the best managers in each of the major asset classes—domestic and foreign stocks, investment grade and high yield bonds, real estate—and specific investment styles (e.g. value, growth, small cap, etc.) Our goal is to identify firms where the people and process can provide meaningful outperformance over a market cycle, i.e. a buy and hold strategy. As a result, our portfolios experience relatively low turnover which normally means fewer trades and greater tax efficiency.

         In the taxable versions of our asset allocation portfolios, i.e. Conservative to Aggressive Growth, we use municipal bond funds for the fixed income allocation. Since the onset of the credit crunch and the problems with monoline insurers, muni bond prices have been under pressure for technical reasons. However, we think that yields and valuations are currently very attractive on munis and our portfolios have been fully allocated to this sector since early 2008.

         Our asset allocation portfolios are currently positioned with an overweight to large cap growth stocks versus our strategic asset allocation. Without taking into account any potential tax law changes, we think the valuations are very attractive in this sector and also believe that the global nature of most large cap companies could help to soften the earnings impact of any U.S. economic slowdown.

         Although we monitor legislative and political developments as part of our investment process, given their inherent uncertainty, these considerations generally are secondary elements. Valuations, managing risk, and positioning the portfolios for good total return performance over the next few years are our primary considerations. Recent market dislocations virtually across the board are presenting attractive valuations and buying opportunities for our fund managers. We believe the portfolios are well-positioned to take advantage of the eventual market rebound and properly diversified to provide downside protection from market volatility.

Morningstar Investment Services, Inc.

The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Please consult with your financial advisor before making any investment decisions. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar Investment Services shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. Please note references to specific securities, mutual funds or other investment options within this piece should not be considered an offer (as defined by the Securities and Exchange Act) to purchase or sell that specific investment. Past performance does not indicate or guarantee future returns. An investment’s value will fluctuate, in which case an individual’s investment, when redeemed, may be worth more or less than the original investment. Investments in high yield bonds involve greater risk due to lower credit quality of the issuers. Please consult with your financial advisor if you have any questions about this piece.