In the past, total political party control of the Presidency and Congress has been neutral or positive for the stock market and the economy. In recent years, however, both political parties have become more extreme. The critical change is that now the Democratic Party is proposing to increase the corporate tax rate to 28%, a whopping 33% increase from the current 21%. The last time the US raised the corporate tax rate was 1949.
Meanwhile, the rest of the world, including socialist-leaning European countries, continues to gradually lower corporate taxes with the European rate currently averaging 21.3%. These European countries have recognized that the most effective way to fund extensive social benefits is to have low, competitive corporate tax rates that encourage companies to invest and create jobs in their countries, and then heavily tax the employees of those companies with a high payroll, income, sales and real estate taxes.
Increasing the corporate tax rate to 28% will make the US a much less competitive place to make investments globally and will likely lead to a decline in investment, economic growth, and job growth. In addition, there will be a direct and immediate impact on US corporate profits as the tax is implemented and after-tax profits decline. In fact, our 6,000 target on the S&P 500 Index would drop to 5,000 due to lower earnings and a lower multiple to reflect a lower expected earnings growth rate. Although a 5,000 target seems unlikely as the index approaches 6,000, it is important to note that a Democratic sweep will also imply a large increase in the capital gains tax which is likely to trigger widespread selling of stocks to harvest capital gains, as it did in 1986 after the last significant increase in the capital gains tax rate.
The good news is that the odds of a democratic sweep are declining according to political betting sites. According to electioobettingodds.com, Trump is favored by 53.7% to 45.7%, the Democrats are favored by 55.1% to 44.9% to take the House, and the Republicans are favored 77.3% to 27.7% in the Senate. Based on these betting odds (using cumulative probabilities) there is less than a 5.7% chance of a Democratic sweep, an 18.3% chance of a Republican sweep, and a 76.0% chance of a divided government. These odds validate our 6,000 target based on the most likely case being a divided government. A divided government would be bullish for stocks resulting in stable regulatory policy and lower government spending as the opposition party typically opposes the new spending initiatives of the party controlling the White House. We see most of the risk to our 6,000 target to be to the upside, as investor optimism about Fed rate cuts, the AI technology boom, and election results propels the market above our fair value estimate. It is normal and efficient during new technology booms for stock prices to move above fair value as optimism about technology leads to high stock prices that then stimulate capital flows into public and private markets, which speeds the development of the promising technology. We expect interest rates to gradually drop into the 3.5% area as global rate cuts continue and central banks will inject liquidity into the global capital markets.
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