Republican Midterm Election Victories Could Sink Stocks and Bonds

By: Money_Morning

Shah Gilani writes: Markets have rallied on the belief that resounding Republican victories in yesterday's (Tuesday's) midterm elections will reset Washington agendas and lead to more business-friendly policies.

However, market participants may be surprised to find that the successful pursuit of three major Republican principles could initially sink stocks and bonds before creating a base from which they might rally later in 2011.

Indeed, following the adage "buy the rumor, sell the news" might be the best strategy for investors right now.

Republicans generally advocate a strong dollar, lower taxes and less government spending.

But consider the following three points:

1. Any sudden and dramatic rise in the dollar would initially reverse the profitable overseas revenues of corporations, lower earnings expectations and sink stocks.
2. Tax cuts - without off-setting spending cuts on pork-barrel and budget-busting special interest giveaways - would initially increase the deficit and sink bonds.
3. And a rush to cut government spending on entitlements, unemployment benefits and stimulus programs would initially panic consumers and slow economic growth.

In the long-term, a strong dollar, lower taxes and less government spending are exactly what this country needs. But, in the short-term, politically motivated quick fixes could panic markets.

Here's a look at what the markets are facing and where they may go.

Historically, stocks rally strongly after midterm elections. Then again, historically, September and October are the worst months for stocks. Since markets just had their best September-October run in 70 years, history may not be our best guide at this juncture.

First, it's important to understand why stocks, commodities, gold and bonds have been rising while housing prices keep falling, unemployment remains stuck near 10%, and none of our too-big-to-fail banks are out of the woods.

Rallying markets are being driven by a falling dollar and the U.S. Federal Reserve's quantitative easing stimulus.

Stocks prices are rising because companies are increasingly generating revenues in the global marketplace. In spite of flat U.S. growth prospects, emerging markets and developed world economies have an appetite for U.S. goods and services. The falling dollar raises the purchasing power of our trading partners around the world.

More importantly, when earnings generated in foreign currencies are translated back into cheaper dollars, the foreign exchange gain drives sales numbers and net profits higher.

Higher earnings combined with the tax advantages of channeling overseas revenues through off-shore tax havens, used by the likes of Google Inc. (Nasdaq: GOOG), Microsoft Corp. (Nasdaq: MSFT), Johnson & Johnson (NYSE: JNJ) and other giant multinationals, have been driving robust stock market gains.

The falling dollar also has been driving commodity prices higher because most commodities are priced in dollars. A falling dollar means it takes more dollars to buy the same quantity of a commodity.

Additionally, commodities have been rallying, as has gold, because investors fear that the dollar, the world's main reserve currency, is losing its status as a safe haven investment.

The debasement of the greenback by the incessant printing of dollars to buy an endless stream of bills, notes and bonds issued by Treasury to finance the growing American deficit is creating a widespread fear of future inflation.

Commodities and gold are traditionally excellent hedges against rising inflation, which is another reason they have been rallying.

The Federal Reserve has been doing its part to keep the dollar weak by promising a second round of quantitative easing, or "QE2" as it's being called, which will result in the central bank buying more government bonds and mortgage-backed securities to keep interest rates low to stimulate the economy.

In the short-run, the Fed's intention to drive real interest rates into negative territory has been a boon for bond prices.

Printing dollars to keep interest rates low also has inspired leveraged bets on commodities, gold, bonds and stocks. But, while yield-hungry investors reach for higher returns, low rates haven't helped the economy or impacted high unemployment.

Enter the Republicans.

Swinging the economic, financial and regulatory pendulum from one political extreme to the other has only driven us from boom to bust to boom and back again, over and over.

Republican principles are good for America - but so are Democratic principles.

The Republican agenda is about more than just the pursuit of a strong dollar, lower taxes and less government. And, the Democratic agenda is about more than just the pursuit of a social safety net, equal rights and conscientious government.

The problems we're facing as a capitalist-democracy can't be answered just by Democrats or just by Republicans. They were never meant to be. We are a nation of free men and free thinkers. And, by the grand design of our Founding Fathers we are supposed to debate the agendas before us and let the majority decide our direction.

I'm not for the Republicans and I'm not for the Democrats. They are like gangs to me. They might as well be the Sharks and the Jets, or the Bloods and the Crips. They're fighting over turf. Only it's not their turf, it's our America, and they are destroying it.

Until we see the gang warfare stop and thoughtful, bipartisan debate and bipartisan legislation enacted to fix the long-term problems and economic difficulties America faces, we might do well to take any profits we have on the news of these midterm elections.

There will be bloodletting and it may prove prudent to keep your investment capital out of harms way.

But, if our legislators begin to take prudent action and promise to work together to address the harmful unintended consequences that result from honest and fair regulations and laws they enact - that's a farfetched rumor I would buy on.

[Editor's Note: Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.

When that downdraft came, Gilani was ready - and so were subscribers to his new advisory service: The Capital Wave Forecast. The next morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.

Gilani shows investors the monster "capital waves" now forming, and carefully demonstrates how to profit from every one.

But he doesn't stop there. He's also the consummate risk manager. As the article above demonstrates, Gilani also makes sure to highlight the market pitfalls that can ruin years of careful investing and saving.

Take a moment to check out Gilani's capital-wave-investing strategy - and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. Those essays can be accessed by clicking here.]

Source : http://moneymorning.com/2010/11/02/...

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