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?

Traders. Click image to expand.
Will traders be happy come Tuesday?

Come Tuesday, the United States will almost certainly have a divided Congress, with Republicans taking the House and Democrats holding the Senate. That spells legislative gridlock. The prospects are slim for the 112th Congress passing a climate bill, tax-code reform, immigration reform, entitlement reform, or legislation on any of a dozen other issues.

But stalemate in Washington often translates to surge on Wall Street—at least that's what people on Wall Street like to say. "Markets love gridlock," billionaire investor Kenneth Fisher told Bloomberg, predicting a rally before and after Tuesday. "What the market wants to see is no change—less legislation that engages in changes in taxes, spending, regulation, or property rights."

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Figuring out how politics affects the markets is a favorite parlor game of stock analysts. And when it comes to control of Congress, the consensus has always been in favor of divided governments—they're less likely to get anything done, meaning less regulatory or legislative uncertainty for businesses. If small government is good, the theory goes, then hamstrung government is better. But recent research shows a more complicated picture. In fact, some Wall Street types are bracing for the new Congress to usher in a bear, rather than a bull.

One thing is certain: Markets love midterm elections. Brian Gendreau, a market strategist for Financial Network, found that the Dow has risen after 19 of the 22 most recent midterms. From 1922 to 2006, the Dow jumped 8.5 percent in the 90 trading days following the midterms, versus just 3.6 percent in non-midterm-election years.

Gendreau has two theories for the findings. The first is the oft-repeated gridlock theory: Midterms generally result in a more even distribution of power in government, and markets generally smile on the diminished possibility of legislative meddling. A second, related theory relates to uncertainty. Before midterms, markets are unsure of what priorities Congress will have. After midterms, they have more certainty—so investors worry less and stocks rally.

So the midterm elections themselves give the stock markets a bounce. But what about what comes after the elections—in this case, gridlock?

There, research shows that gridlock—contrary to general opinion on Wall Street—does not actually do much for stocks. Sam Stovall, the chief investment strategist for Standard & Poor's Equity Research Services, finds that gridlocked Congresses hurt the markets—and that the combination of a Republican House, a Democratic Senate, and a Democratic White House might be particularly awful.

Stovall studied the performance of the S&P 500 from 1900 until this year under three scenarios: total unity (one party controlling the House, Senate, and White House), partial gridlock (one party controlling both houses of Congress and the other controlling the White House), and total gridlock (a divided Congress).

Over all years, the S&P rose at a 6.8 percent annual pace. During times of total unity, 67 of the 111 years analyzed, it gained 7.6 percent annual pace. During times of partial gridlock, accounting for 32 years, they gained 6.8 percent. And during the 12 years of a gridlocked Congress, the S&P gained just 2 percent per year. Looking at more recent years, since 1945, the pattern holds. Under total unity, stocks climbed at a 10.7 percent annual pace. Under partial gridlock, they gained 7.6 percent per year. And under total gridlock, which accounts for eight of the 65 years, they gained just 3.5 percent per year.

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