What's on voters' minds? The economy, stupid

Dan Cobb, a 60-year-old retiree from Soddy-Daisy, Tenn., will vote with his wallet in the 2008 presidential election.

His retirement portfolio is down more than 8% this year due to the weak economy and resulting stock market slide. He wants the next president to wear the hat of investor-in-chief and help stop the bleeding.

"I am worried about the erosion of my investments," says Cobb, who views the economy as the top issue in the election. "We need (the next president) to rejuvenate the economy and financial markets."

Cobb isn't the only one focused on pocket-book issues as the race for the White House heats up. The entire investment community is, too. The big reason is that stocks are down sharply in 2008. Thursday, the Standard & Poor's 500 index sank to its lowest since September 2006, leaving it down 11.2% for the year.

Wall Street is experiencing financial distress amid the worst housing market since the Great Depression and a drastic drying up of credit. That double-whammy has the economy on the brink of recession. Thus, investors are scrutinizing the potential market-moving policies of the three remaining candidates: Republican John McCain, who wrapped up his nomination this week; and Democrats Hillary Clinton and Barack Obama.

"When the economy is not functioning well there is greater clamoring for reforms and changes," says UBS strategist Thomas Doerflinger.

Indeed, the interests of Wall Street's masters of the universe and Pennsylvania Avenue's political power brokers are intersecting to a degree not seen in years. Nearly nine out of 10 investment advisers (84%) at Charles Schwab — the folks who manage money for individual investors — said the economy was the "decisive" issue in the upcoming election, topping the war in Iraq by more than 20 percentage points.

Daniel Clifton, an analyst at Strategas Research Partners, says this election is the most important one for investors since 1980, when Ronald Reagan swept into office on a pro-business platform after the stock and business malaise of the 1970s. The campaign also harkens back to 1992, when Bill Clinton captured the White House with the help of the catchy slogan, "It's the economy, stupid," says Allan Sinai, chief global strategist at Decision Economics.

The next president is faced with major economic challenges. Stocks are flirting with a bear market. A recession is looming. Home prices are falling. Foreclosures are up sharply. Jobs are harder to come by. Oil fetches more than $100 a barrel. Inflation is worsening. And one-time fledgling economies such as China and India have become legitimate competitors to U.S. business in a world that has truly gone global.

All these headwinds are interconnected, complex and potentially toxic to a portfolio. How the next president deals with them could determine if they are resolved in an investor-friendly fashion.

"This election is about leadership," says Sinai. "The next president must come to grips with the notion that, despite the U.S. still being a great economic power, we are suffering from an erosion of our economic and financial power in the global economy."

Wall Street has tracked the relationship between politics and stocks for decades. Despite Republicans' reputation as being better for the stock market — thanks to the conservative party's proclivity for low taxes, free trade and fiscal responsibility — stocks have actually fared better under Democratic presidents. The Dow Jones industrial average has risen 7.2% per year, on average since 1901, under Democratic presidents, compared with a 3.8% gain when Republicans were in the Oval Office, says Ned Davis Research.

To be sure, the president can't move markets by leadership alone. It is the policies, not the politician, that affect prices of financial assets most.

"Investors have a lot at stake in this election," says Massie Ritsch, spokesman at the Center for Responsive Politics, or CRP, a group that tracks campaign contributions. "The president and Congress can make life either very easy or very hard for Wall Street."

That's why employees at Wall Street firms, in an effort to protect their interests, again top the list of top campaign contributors. Employees at investment bank Goldman Sachs have contributed $1.6 million in the 2008 election cycle, making them the No. 1 corporate contributor, CRP says.

Overall, Democratic candidates have received more money than Republicans. Through the end of January, the latest data available, Obama was the top money-getter, with $36.1 million, compared with $18.9 million for Clinton and $12.6 million for McCain, says CRP.

The election is of particular importance to investors because many of Wall Street's biggest firms have suffered multibillion-dollar losses from the subprime mortgage meltdown. Cash-starved banks have tightened credit standards, making it tougher for individuals and businesses to borrow. The resulting credit crunch has created a sense of gloom on Wall Street.

Main Street is also suffering from economic anxiety. The falling values of homes in most parts of the country have resulted in a negative wealth effect. A growing number of homeowners are having trouble making their mortgage payments. For some the crunch is so severe that they are walking away from their homes, causing foreclosures to skyrocket and further hurting an already weak economy.

Investors are looking for some form of bailout from the federal government as well as signals from the White House hopefuls that they have a plan to fix the ailing housing and financial markets.

"Wealth is under siege. This political cycle has coincided with a period where risk is being repriced and where our economy is at its most vulnerable," says Adrian Cronje of Wilmington Trust's Wealth Advisory Services.

So what issues worry investors most — and where do the remaining candidates stand on the issues?

In general, Wall Street prefers policies that are pro-growth, especially when the economy is sluggish, as it is now. So it's no surprise that investors' main focus is on taxes, free trade, government regulation and spending programs.

Debate over Bush tax cuts

President Bush pushed for and got investor-friendly tax breaks in 2003. He lowered the tax on capital gains to 15% from 20%. He also slashed the tax on dividends to 15%; prior to the cut they were taxed at a tax filer's regular income tax rate. Those tax cuts are set to expire at the end of 2010.

McCain wants the Bush tax cuts to be made permanent, arguing that lower taxes on investment gains are a powerful economic stimulus. Obama and Clinton argue that the low tax rates on stock profits and dividends favor the wealthy. Both Democratic candidates want to let the Bush tax cuts expire and instead provide tax relief to the middle class.

Not extending the tax cuts, Sinai says, would equate to a tax increase.

"Tax increases are OK when the economy is booming but not OK when the economy is doing poorly," Sinai says. Higher taxes leave consumers with less to spend, he says. And taking a bigger tax chunk out of capital gains and dividends "will discourage investment in stocks." It will also impede the flow of capital through markets, Sinai adds, making it more difficult to finance new investment.

Bob Martin, an individual investor from Palestine, Texas, says if taxes on stock gains go up, "I will sell stocks and buy (tax-free) municipal bonds to cut my taxable income."

In contrast, the Democrats are likely to argue that higher tax rates under President Bill Clinton did not hurt economic growth during his administration, says Clifton. They will also sell the virtues of putting more much-needed disposable income back into the paychecks of America's strapped middle class.

Clifton predicts that if either Obama or Clinton wins the White House, he or she will likely raise the taxes on capital gains and dividends to fund new initiatives, such as universal health care and more stringent environmental protections.

Tussle over free trade

It's no secret that business has gone global and trade barriers have fallen, creating both winners and losers in the USA. Jobs have been outsourced abroad. The fairness of trade treaties is being questioned. And there's a concern the situation is now tilted toward foreign competitors and that the playing field needs to be leveled.

But it would be dangerous to "go down the path of protectionism," says Joseph Quinlan, chief market strategist at Bank of America. He notes that the USA has never been more dependent on foreign oil, foreign capital and cheap foreign labor.

Says Quinlan, "We need trade policies that champion open free trade and cross-border investments."

McCain has said that he will fight protectionism, and that the "rising tide of economic isolationism is threatening our entrepreneurs."

Clinton and Obama argue that trade policies must work for average Americans. Both believe trade treaties, such as the North America Free Trade Agreement, or NAFTA, must be tweaked to better protect U.S. workers and the environment. Obama, for example, has said he will "stand firm against trade agreements that undermine our economic security."

There is a fine line between leveling the playing field and implementing policies deemed protectionist, says Jack Ablin, chief investment officer at Harris Private Bank: "Global forces are so powerful, to take the ball and go home would be a very costly mistake."

Challenge of tackling high-cost programs

Clinton and Obama want universal health care. McCain's health care solution is more market-based. Most economists agree that Social Security, Medicare and other big entitlement programs that are massively underfunded must be addressed by the next president. Energy independence and protecting the environment are also top priorities. But tackling those problems costs money. "The spending side is important," Clifton says.

Once everything is added up, it's likely the Democrats wouldn't be able to fund all their proposals, and McCain would have a difficult time holding the line on taxes, adds Cronje. Bottom line: Taxes may rise no matter which party is elected.

Right now, traders are placing their bets at the online Iowa Electronic Markets. As of Thursday, trading indicates that Obama has a 70% chance of winning the Democratic nomination.

And the presidential election? The "market" is betting that Democrats will grab 54% of the popular vote, vs. 46% for Republicans.

The collision course between Wall Street and the White House is still playing out.

Ed Yardeni of Yardeni Research sums up the relationship between Wall Street and the federal government this way: "Wall Street is all about profits, and the extent to which the government has an impact on those profits matters a great deal. The government can do stuff that can contribute to a bull market but also implement policies that are bearish for the market."