Why is the stock market looking forward to political gridlock?

Commentary about business and finance.
Nov. 1 2010 11:46 AM

Election Day Prediction: Buy

Why is the stock market looking forward to political gridlock?

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Of course, it's possible that gridlock is the result of a bad economy: Congress and the voting public can't agree on a way out of the mess. And Stovall allows that his analysis might be "simply another example of coincidental correlation." But, in a note to investors, he argues that the reason total gridlock hurts big stocks is uncertainty. Divided governments do not lay out their priorities, and the infighting endemic to gridlocked Congresses hurts businesses. "Should a split Congress be the result of the November 2 elections, the resulting uncertainty may just end up adding one more stone to this already high wall of worry, limiting the otherwise strong performance that is typically seen in a president's third year in office," Stovall concluded.

But Stovall only looked at the S&P 500. What about the market as a whole? Scott Beyer of the University of Wisconsin-Oshkosh, Gerald Jensen of Northern Illinois University, and Robert Johnson of the CFA Institute examined broader market returns in a 2004 article for the Journal of Portfolio Management.

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Like Stovall, they found that big-company stocks suffer during times of gridlock—returning 0.8 percentage points less during times of unified government. But gridlock really hurts small stocks—the equity of little companies with less ability to adapt. During times of unity, they returned an annualized 23.5 percent. During times of gridlock, they returned 11.4 percent per year.

Many market analysts therefore are discounting the old wisdom that, for Wall Street, if the opposite of pro is con, the opposite of progress is Congress. They are bracing for the gridlock to have a deleterious impact on the stock markets. Andy Busch, a currency and public policy strategist for BMO Capital Markets, thinks investors are wearing rose-colored glasses when it comes to the next two years, at least where equities are concerned. "The markets are anticipating a reauthorization of the Bush tax cuts during the lame duck session," Busch says. "They are pricing that in, and they could be seriously disappointed by a failure to fix the taxes, by uncertainty around taxes, by smaller-than-expected quantitative easing. If the capital gains tax goes up, especially, that is going to be bad for investment in stocks."

Then there are the Republican promises to be inactive in legislating but seriously active in defunding or attempting to repeal Obama's legislative successes—introducing a whole lot of uncertainty into already-shaky markets. The GOP is intent on "repealing Obamacare lock, stock, and barrel," Rep. Mike Pence, R-Ind., recently told CNN. "There will be no compromise on ending this era of runaway spending, deficits, and debt."

The markets might not be taking the impact of such chaos into account. Consider the recent results of a poll by FTI Consulting. Most businesses and investors surveyed disapproved of President Obama and said that Democrats have increased uncertainty, hurting their businesses. About 63 percent say that things will get better under the gridlocked scenario. But more than half—and two-thirds of likely voters within the responding pool—say that Republicans should try to work with Democrats, rather than trying to repeal Obama's health care reform bill and to defund big initiatives.

In short: They really want the gridlocked Congress to avoid doing anything at all. At the very least, some Republicans are trying to give them what they're hoping for.

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Annie Lowrey is a contributing editor for New York magazine. She can be reached at annie.lowrey@gmail.com.

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