In the wake of yesterday’s stunning election in Massachusetts, why did the equity markets endure the steepest losses of 2010? After all, markets rallied on Election Day in anticipation of the Republican victory. CNBC’s Jim Cramer used much of his show to urge viewers to “Buy, Buy, Buy!”, based on his belief that gridlock will reign in Washington.

While most pundits are busy overstating the Democrats’ loss of a filibuster-proof majority in the Senate, declaring health care reform dead and projecting massive Republican gains in November, the election did give rise to one potential outcome that has important implications for the markets. That is, voters have clearly rejected runaway government spending and huge budget deficits and bailouts, without regard to which political party is responsible. As a result, expectations of additional government stimulus programs and so-called “quantitative easing” by the Federal Reserve should be scaled back. In short, the Fed’s printing press is now running a little short of ink.

So let’s think of the investment implications. First and foremost, this is positive for the value of the US dollar and bullish longer term for the markets. Our leaders have steadily debased our currency and reduced our standard of living through the Fed’s zero interest rate policy and our trillion dollar budget deficits. Any improvement on this front is likely to be met with a rise in the dollar, and in fact the dollar is up about 1.5% over the last two days. The chart below shows that the dollar bottomed on Thanksgiving and recently made a higher low. We think the dollar may move significantly higher.

One other major implication of less government stimulus is that the private sector economy must shoulder more of the burden. This is the handoff of the drivers of economic growth that we have discussed in recent months. After a liquidity-driven rally of near 70% in the equity markets since last March, investors are expecting solid growth in 2010. Perhaps today’s market reaction, even in the face of good earnings news from IBM, reflects concern that growth may not be quite as robust in an environment of fading government stimulus.

Election Results

Disclosures

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.

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