As we have discussed many times, tax policies have serious investment consequences. The higher the capital gains tax rate, the higher the pre-tax rate of return investors require which in turn leads to lower equity prices. Further, due to the compound nature of return embedded in growth stocks, higher capital gains taxes will have a more negative effect on growth stocks than value stocks. We created the Palin Barracuda Index (PBI) to track the likely effect of the winning Presidential Candidate’s tax policies on the stock market. The basic premise is that under an Obama Administration, capital gains taxes will increase and value stocks should perform relatively better than growth stocks, conversely a McCain Administration should make growth stocks relatively more attractive.
The last update to the PBI took place on September 12th, showing the race to be a toss-up at the time, but leaning towards McCain. Since then, the index has moved decidedly in favor of value stocks, with a reading as of September 15th (before the last debate) of 97.6, a drop of 3.8 points. The credit crisis has distorted the index in the short term, along with most other market metrics, as decreased liquidity will more adversely effect growth stocks which rely on more external financing to achieve their business plans than value stocks. However, the movement in towards value stocks has also been very consistent with a new set of policies that portend higher capital costs in the near future.
Bottom line, the recent changes in the index certainly point towards an Obama victory but I would not place much value in the index readings since the credit crisis started. It will be interesting to see if the markets calm down where the PBI settles in the next couple weeks as we finish the election. It might just be that Obama gets a pass for a while raising the capital gains tax rate since in the short run there will only be capital losses and therefore tax policy is irrelevant for a while.
