Election Day Prediction: Buy

Why is the stock market looking forward to political gridlock?

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.”

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.

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.

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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