Jon D. Markman
Stocks Handcuffed if Rove, Libby Indicted
 By Jon D. Markman
RealMoney.com Contributor

10/26/2005 11:01 AM EDT
URL: http://www.thestreet.com/p/rmoney/jondmarkman/10249416.html
 Market Overview
  • The White House could face a crisis if the influential aides are indicted.
  • Upheaval could lead Bush to make policy mistakes and business-unfriendly compromises from a weakened position.
  • If Congress is distracted, lower tax rates on dividends and capital gains could sunset.

    • As the stock market flops around like a wounded sockeye on the deck of a sinking ship, most of the blame is being focused on underwhelming economic growth, swelling inflation, energy price volatility, the Fed's relentless drive to crush home-buying speculation, the Refco bankruptcy, insider selling and plain old seasonality.

    All of these are certainly playing a role, in varying degrees, in investors' extraordinary indecisiveness on whether to buy, hold or throw away stocks. But there may be one more hidden factor that is preying on investors' emotions, even if they don't recognize it yet. And that is the increasing possibility of a political crisis over the potential indictments of leading White House advisers I. Lewis Libby Jr. and Karl Rove.

    I'm not saying that either of these aides will be indicted by special prosecutor Patrick Fitzgerald. Or that it will lead to a crisis of leadership. I'm just saying that the possibility of high-level indictments is only being hinted at in the recent market malaise, and that if it really happens, there could be a profound negative effect.

    The Watergate Effect

    While we tend to remember the 1973-74 market crash as coincident with a tripling of energy prices (due to the OPEC oil embargo), it also coincided with the drumbeat of congressional investigations, indictments and convictions over the Watergate break-in and cover-up.

    The top of the market in that period was November 1972, just after President Nixon's re-election over George McGovern. The scandal began to unravel soon after that, with G. Gordon Liddy and James McCord, two Republican Party operatives, convicted of breaking into the Democrats' campaign headquarters in January 1973.

    Over the next 18 months, the Nasdaq Composite fell 55% and the Dow Jones Industrial Average fell by about half. The decline -- which also coincided with a recession and the end of the Vietnam War -- drained money day after day from the stock market until the autumn of 1974. You may recall that Nixon, under threat of impeachment, resigned in August of that year. That lifted the market's mood a bit, but the final bottom didn't come for two more months, a short time after President Ford pardoned Nixon in September.

    How the Markets Could Lose

    Fast forwarding to today, there is no telling if Fitzgerald's investigation into a conspiracy to leak secret CIA information to punish a Bush administration critic will yield indictments. But if they come, there are two ways for the administration, and the market, to lose.

    If Rove is targeted, President Bush either loses his indispensable political strategist or he spends a lot of political capital defending him and keeping him in the White House. Take your pick -- they're both bad outcomes. As ISI Group analyst Tom Gallagher said in a report last week, "Wagon trains pulled into a circle don't make a lot of forward progress."

    The investigation of GOP lobbyist Jack Abramoff and the indictment of Rep. Tom DeLay are already causing a lot of problems in Congress, and dragging Rove or Libby through the courts would make matters worse. As noted by Gallagher, here are some possible effects on businesses and stocks if Congress is distracted:

  • The lower tax rates on dividends and capital gains could "sunset," i.e., lapse without being renewed.

  • Republicans could head into the midterm elections with a risk of losing their congressional majority, which would potentially have repercussions in such areas as health care.

  • The upheaval would probably lead to policy mistakes that could allow the balance of power to shift from a strong White House to resurgent Democrats in Congress. In compromises from a weakened position, you could see Bush accept more foreign trade restrictions, for instance, which the market does not like.

    • This is all taking place against a backdrop of other factors that investors fear. One of the key elements, of course, is higher short-term interest rates. While many appear to believe that the Federal Reserve is likely to halt its rate-hiking campaign soon, I have my doubts.

    It's important to note that the Weekly Leading Index of the Economic Cycle Research Institute, which has done a great job of forecasting recessions over the past two decades, does not show a recession on the six-month horizon. That's good news for the economy but bad news for people who think weakness will spur the Fed to stop raising rates.

    An improved economy gives the Fed free rein to hike. At the same time, the Future Inflation Gauge of the ECRI is at a five-and-a-half-year high. Put those two together, and you pretty much have to view the Fed to be in inflation-fighting mode, which means it will keep raising.

    I'll throw one more carrot in the troublesome stew by noting that, according to weather researchers, whenever there have been five Category 5 hurricanes in a single season, the following November has been unusually cold in the Northeast.

    If it were to happen again, oil and refined petroleum prices, which have just come into support at the end of this week, could start moving up again. The analyses I have seen have noted that because there was such a rush to refine gasoline following hurricanes Katrina and Rita, heating oil inventory is very low in the Northeast. If there is high demand, watch out.

    Add it all up, and you have a bleak picture forming for the next year: Potentially a highly distracting political scandal, economic stagnation without the cleansing finality of a real recession and higher energy prices that sap consumer spending. That sounds like 1970s-era "stagflation." Get out your leisure suits, put on your John Dean glasses and turn up the disco music.
    Jon Markman, writer of TheStreet.com Value Investor, is the senior investment strategist and portfolio manager at Greenbook Investment Management, a division of Greenbook Financial Services. Separately, he is publisher of StockTactics Advisor, an independent weekly investment research service. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback; click here to send him an email.

    Interested in more writings from Jon Markman? Check out his newsletter, TheStreet.com Value Investor. For more information, click here.