With the Republican National Convention in full swing this week, we thought we’d explore how the November election could affect our investment strategy.

The economy and the stock market are much bigger than any one elected official, even the President. That said, the executive branch’s economic policy can move markets, particularly certain types of securities.

As MAXadvisor subscribers know, we don’t trade frequently or make major shifts in the portfolios based on short term predictions in the market. We do, however, devote small percentages of our model portfolios to areas of the market we think are currently undervalued. Even our broad allocations to stocks and bonds are based partially on current valuations and what we expect to happen in the future. As the election of either President Bush or John Kerry could affect the direction of the U.S. economy, it is certainly worth exploring how the election of each could influence our investments.

A good example of an investment that could benefit based on which candidate is in the oval office is municipal bonds. Muni bonds are priced by the higher tax brackets. This means muni bonds after-tax yield goes way up if upper tax brackets are increased significantly. Kerry wants to return the highest tax brackets to Clinton-era levels by reversing some of the Bush tax cuts. Such a move could give a small boost to muni bond prices.

Kerry wants to offer at least basic health insurance to the 45 million Americans currently without health coverage. Depending on the intricacies of such a plan, beneficiaries could include drug and health insurance companies, as well as hospital operators (who get stuck with unpaid bills from the uninsured).

Not that the health care sector will suffer under President Bush. His recent Medicare drug benefit plan could cost $500 billion over ten years. More subsidized drugs for seniors mean more drug sales for big pharma.

President Bush is a big proponent of an “ownership society”. What this means in practice is more IRA-like vehicles to pay for things like health care and education. Partial privatization of social security, as well as a myriad of retirement accounts, some with new increased limits, will likely benefit stock prices. While it won’t improve earnings, the extra demand for investments will lift valuations (imagine some Social Security payroll taxes getting funneled into the stock market!)

The financial services industry, specifically mutual funds and brokers, will benefit from this ownership society in much the same way they currently benefit from the 401(k) system. What was once low-management-fee pension accounts is now a short list of higher-fee mutual funds that employees must choose from in their company sponsored retirement accounts.

On the flipside, a “Handout Society” (presumably what Republicans will call the other side’s schemes) can benefit retailers, among other areas. Kerry’s policies should put more money in the pocket of the consumer class and could increase demand for products and services – and increase corporate profits. We’ll likely see higher stock prices under Bush, but higher, possibly unstable, valuations, and flat to lower stock prices under Kerry, but with lower stock valuations. With Bush, you have more money going into stocks; with Kerry, you have more money going into consumer spending.

What we won’t see is a further drop in bond yields, as could be the case if either party stopped spending money they don’t have. With fewer new government notes and bonds hitting the market, investor demand would have to go to corporate bonds and existing bonds, lowering yields and lifting bond prices. Cutting spending is simply not in the cards for either party.

But who will win?

As old MAXfunds readers know, we successfully predicted the outcome of the 2000 elections by watching the behavior of two baskets of stocks – the Bush and Gore portfolios. The lists were comprised of the biggest corporate backers of each party - stocks that would have benefited from their favored party getting elected (why else give so much loot?).

This year things are more difficult to read. Campaign finance reform means giant donations from companies is verboten. Instead or following the money, we’ll have to rely on history. We’ve looked at the Dow and how it behaved over the last 100 years around election time.

Often, a weak stock market in an election year is a good sign the incumbent party will not be in the Whitehouse the following year. Specifically, if the market is not up in the six weeks leading up to an election, the incumbent party has a 92% chance of loosing the election.

Coincidence? Probably not. The country is often evenly divided into Republicans and Democrats – those who will vote for their party’s candidate regardless of who it is. The election is therefore decided by the swing voters.

The stock market reflects future earnings potential. Imbedded in these estimates are perceptions about the economy. Consumer, business executive, and investor confidence are related, and if people feel things are not going well, they are more likely to spend less, hire less, and invest less. They are also more inclined to vote for a party change.

Such fears are reflected in stock prices directly, as investor’s enthusiasm for stocks wanes. These fears can lead to actual drops in consumer spending, home buying, business hiring, new business startups, and more. When the results of this behavior is tabulated and circulated, it can lead to further market declines. In this way the stock market in the weeks leading up to an election is a barometer for how those who may go either way on Election Day may vote.

There may be nothing to fear but fear itself, but for a president facing re-election, investor fear could mean everything. The major markets are down slightly for the year, which doesn’t bode well for President Bush’s re-election hopes. There is, of course, still time for the markets to rebound before the Tuesday after the first Monday in November.