U.S. elections ahead & how Canada has plunge a lesson for U.S. investors

For all the pundits out there claiming that the U.S. midterm elections next week won't mean anything for the stock market, take a good look at the Canadian stock market plunge Wednesday.

Canada's S&P/TSX Index in Toronto fell 2.4%, its worst showing since early this summer, and some of its companies fell between 11% and 19% in a vicious bout of selling sparked by a government announcement that it will close a tax loophole on income trusts that had led to a surge in big companies converting to trust status to avoid taxes. The income trust sector of the market fell more than 10%.

Whether the Canadian government is right or wrong to close this loophole isn't the issue for U.S. investors, although many Canadian companies that trade in the U.S. also got hit. What's important is that the announcement came as a complete surprise to the market, despite a robust debate about the status of these securities. It shows that when governments want to, they can have an immediate and powerful effect on markets.

And that's the lesson investors should take to the polls here in the U.S. next week.

While we haven't had an incident like the income trust one in Canada, we certainly have seen examples of government action that has shaken markets. Just this summer, the government's effort to go after Internet gambling sites stunned the shares of those sites - foreign listed - as investors suddenly bailed out of a strategy they never thought would turn on them so quickly.

The stock option backdating investigations by the government, while mostly tied to tech companies, have also shown how otherwise rosy company stock stories can suddenly become nightmares when the regulators show their hands.

Indeed, the biggest example may be the 1987 stock market crash, 19 years ago this month. The Dow Jones Industrial Average fell 22% on Black Monday, in what would be the equivalent of some 2,600 points at today's Dow levels.

Who knows what might be making its way through Congress right now that could strike the markets in this way, or even in a positive way? Just the fact that it can happen is reason enough to pay close attention to the elections next week.

My own feeling is that the stock market surge in October is a signal that the market felt the Republicans will hang on to both the Senate and the House. That the market has turned around in the past four days may reflect an emerging consensus that the Democrats might just pull it off.

But there are plenty of pundits who feel exactly the opposite - that the rising market was forecasting a Democratic victory in the House and gridlock in Congress for the next 2 years. And that the turn in the past few days is the real signal that the Republicans will hold on.

Whoever comes out ahead on Tuesday will have 2 years to make a lot of progress, or cause a lot of trouble, depending how you look at the world. The only thing that's certain is that the markets will be looking, and when they see something they don't like, they will react without warning or mercy.