Wall Street gets its gridlock wish; how soon till they regret it?

November 3, 2010: 1:12 PM ET

Financial pundits were for gridlock, until they were against it. Why? There's limited data, but historians think it might be the worst possible kind for the markets.

By Mina Kimes, writer

Gridlock has come to the Hill--but will it benefit stocks? Earlier in the summer, market pundits came out in favor of a split Congress, arguing that a disempowered government would leave business alone and eliminate regulatory uncertainty. In recent days, though, investor sentiment has turned against gridlock, with many citing an S&P study that shows that stocks actually perform better during times of unity, not division.

But a closer look at the study reveals that the current situation--a Democratic president and a split Congress--is unprecedented, at least since 1900. As a result, the government is about to enter a state of gridlock that the market has never seen before.

According to S&P chief investment strategist Sam Stovall, stocks have averaged 7.6% returns during "unity" years and 2% returns when Congress is split (which he calls "total gridlock"). The only setup that has generated negative returns on average is a Democratic president and split Congress, which would seem to bode poorly for the next two years.

That setup, however, has only occurred twice since 1900. Those years, says Stovall, were 1917 and 1918--a period during which the Republicans dominated the House of Representatives, but Democrats actually controlled the chamber with the help of the Progressive Party. "Technically, there has never been a time when we had a Democratic president and a split Congress," he says.

"Total gridlock" has not born out well for stocks in ten other years, averaging 3.2% returns on average. But that, too, is a small sample, and it is distorted by severe losses during the Nixon administration and first part of the George W. Bush's presidency, both periods during which the stock market crashed.

In fact, while "total unity" is the most desirable outcome on average for stocks, one of the best possible situations is actually a "partial gridlock" state in which a Democratic president is coupled with a wholly Republican Congress, a pairing that has generated 11% returns since 1900. Yet again, that setup has only happened in ten years, in comparison to 38 years of Democratic total unity. Five of those ten years were during the tech boom.

So both the best--and worst--set ups occurred in relatively small samples, during years in which there were market-moving events (the Nixon shock, the dot com bubble and burst) that would be difficult to pin on regulatory gridlock. That may explain why the best performing sectors in a "total gridlock" state were consumer discretionary and consumer staples stocks, categories that typically benefit from opposite economic conditions.

A recent Oppenheimer report on the correlation between gridlock and economic indicators further clouds the picture. According to that study, which charts data since 1926, when there is gridlock during the second two years of a presidential cycle, the GDP improves--but corporate profits, unemployment, and personal income shrink. In all cases, the results are separated by less than a percentage point.

The past, then, gives us a hazy view of the next two years. But that doesn't mean gridlock won't affect this stock market. Many of the legislative issues that impact business, such as the soon-to-expire Bush-era tax cuts, still await resolution. Without compromise, analysts say, tax breaks on salaries and dividends could wither away.

It doesn't take a historian to see that would be bad for the stock market. It would be bad for business and workers too, because withering away or expiring is the exact opposite of what most business leaders say they want from government: certainty about the country's economic and regulatory course. It's hard to see how this split government will be able to offer business that kind of reassurance.

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