IS political gridlock really good for the stock market?
In 1930, the humorist Will Rogers compared Congress to a baby with a hammer.
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Conventional wisdom, rooted in derisive humor, says it is. “This country has come to feel the same when Congress is in session as we do when the baby gets hold of a hammer,” Will Rogers wrote in The New York Times on July 5, 1930. “It’s just a question of how much damage he can do with it before you can take it away from him.”
He said that while the House had recessed for Independence Day, the Senate, alas, was about to reconvene. “Prosperity will pick up only 50 percent,” he said.
Take Congress’s hammer away, or at least make it impossible for politicians to do much damage with it, and businesspeople will focus on making money. And — presto! — the markets will rise.
That view is still widely held on Wall Street, and it has particular relevance this year, because the Democratic Party, which controls the White House, the House and the Senate, might lose control of Congress in the November election. Total gridlock — with neither party able to enact any major legislation — might follow.
This could provide riveting political theater. But would it help the financial markets?
A review of history suggests that it would not. “The conventional wisdom is that gridlock is good for the stock market, but there’s no evidence that that’s been true over the last 84 years,” said H. Douglas Witte, a finance professor at Missouri State University, who crunched the numbers for Sunday Business.
He defined “governmental gridlock” as a period when no single party controlled the White House and both chambers in Congress. From 1926 through last year, an index of large-capitalization stocks returned about 7 percent, annualized, when there was gridlock, compared with about 12 percent when there was not.
Despite some years of surging stock markets during divided governments in the Reagan and Clinton administrations, those stretches were outweighed in the long historical record by lagging returns in other years.
Oddly enough, while the data doesn’t support the idea that gridlock is beneficial, it does show that stocks fare better when Congress is out of session, much as Rogers suggested. Along with Michael F. Ferguson of the University of Cincinnati, Professor Witte corroborated this finding in a 2006 paper.
The researchers found that more than 90 percent of the price gains over the 108-year life of the Dow Jones industrial average through 2006 came on days when Congress was out of session. And in periods when polls showed that Congress was least popular, this “Congressional effect” was most pronounced.
Their work was inspired by a 1992 article in Barron’s titled, “Legislator Go Home!” by Eric T. Singer, then an investment banker, who reached the same conclusions. Two years ago, he founded the Congressional Effect mutual fund, which has outperformed the market. The fund’s strategy is to abandon stocks when Congress meets, and to invest in them when it recesses.
The idea, he said, is “to capture the returns of the stock market while limiting political risk.”
Why should the Congressional effect work? Professors Witte and Ferguson aren’t sure, but have three possible explanations.
One might be called the Will Rogers-Mark Twain theory. (In his autobiography, Twain wrote: “Suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.”) Because Congress has historically been held in low esteem, this explanation suggests, Congressional activity drags down the public mood, depressing prices.
Another might be called the populist thesis: investors conclude that Congress isn’t acting in the public interest, the professors write, but “rather in the service of powerful financial and economic incumbents,” and this is most obvious when Congress meets.
Most probable, Professor Witte said, is a third explanation, that investors are unnerved by “regulatory uncertainty,” which rises when Congress is active. When the atmosphere clears and Congress goes home, investors are more likely to bid up prices.
But tensions may rise in periods of split government, when the two parties are at loggerheads, and this could add to perceptions of uncertainty, sometimes leading to market underperformance. “Uncertainty seems to be a key factor,” said Tim Hayes, chief investment strategist at Ned Davis Research, an investment consulting firm, who has found that any change in the political control of Congress seems to have a “modestly negative effect” on markets.
A more powerful cyclical effect, he said, is the tendency of markets to rise in the third year of a presidential term, particularly for first-term presidents. But that’s the subject of another column.
If government action is crucial, then gridlock is not an attractive outcome. Ethan S. Harris, chief North American economist at Bank of America Merrill Lynch, says that because of an unusual series of “automatic mechanisms” built into the law this year, if Congress is gridlocked, the result could be “disastrous.”
On Dec. 31, he said, not only do Bush-era tax cuts expire, but tax breaks enacted in the Obama administration’s fiscal stimulus program will also disappear. In addition, he said, there could be a $60 billion tax increase if Congress can’t adjust another levy, the alternative minimum tax. “Put it all together and there is a potential $300 billion shock to the economy,” he said, and that could bring on a recession.
“I can’t imagine a time in modern history where gridlock has been more of a problem than it would be right now,” he said.
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