Political Gridlock May Not Be So Good

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A month ago at this time, political analyst Mark Melcher was "moderately confident" that the Republicans would hold the House and Senate. Today, Melcher, who for years tracked politics and policy for a major Wall Street investment firm and now puts out the Political Forum newsletter (a must-read for the big-money crowd), thinks the Democrats will probably take the House next week. Not that he's thrilled about that prospect–he admittedly leans to the right. But Melcher's not in a panic, either.

Speaking from a financial perspective, "I don't the market will care," he says, doubting much of anything will get done. Indeed, the Dow has been notching record highs as many investors have been taking the "gridlock is good" nostrum to heart.

But maybe they shouldn't. In the September/October issue of the Financial Analysts Journal, there's one of the best studies I've seen on the issue of financial returns and political control. The study looked at stock and bond returns from 1949 through 2004. The study also divided stock returns by the market value and bonds–government and corporate–by duration. For stocks, the study found all size segments did better during periods of harmony–when one party controlled the White House, Senate, and House–than during periods of divided government. And the smaller the stock class, the more it outperformed. There was a half-percentage point difference for the largest 10 percent of stocks. For the smallest 10 percent, the gap increase by more than 20 points, with an average return of 27 percent during harmonious times vs. 4.7 percent during gridlock. The study concludes:

This evidence contradicts the commonly advanced view that equity investors benefit from the lack of legislation enacted during periods of political gridlock. The findings are consistent with the view that the increased incidence of legislative action during periods of political harmony is advantageous to equities–particularly small-cap stocks.

This make some intuitive sense. Gridlock in 2003 would have prevented cuts in the capital gains and dividend rates, a perceived negative for investments. But bonds of all durations, however, did better during gridlock. Long-term governments and corporates returned around 4 or 5 percent during gridlock vs. a slightly negative return during times of political unity. The study's explanation:

Bond markets may prosper during gridlock because the lack of legislative action dampens government spending, inflation, and deficits. According to this view, bonds thrive because interest rates are constrained by the reduced demand for funds by the government (less competition for funds) and because concern about future inflationary pressures is less during gridlock.