True or False: Political Gridlock Is Fuel for the Stock Market

Political gridlock may be bad for the country, but it's good for the stock market, according to an old market adage. But wait: The results of the past 61 years don't bear that out, says one student of the market. Yes they do, replies another market guru. Who's right?

Like the batting averages pored over by fantasy baseball fans, stock market statistics can be sliced and diced in a number of ways. It all depends on who's doing the dicing.

The study of market performance and politics has taken on new importance since Nov. 2, when Republicans took control of the House of Representatives, while Democrats retained control of the Senate. Since 1949, however, there has never been a Democratic president and a split Congress, so there's no direct comparison.

Contrary to Conventional Wisdom

Robert R. Johnson, managing director of the CFA Institute, a nonprofit association in Charlottesville, Va., says the "conventional wisdom that gridlock is good for the market is wrong."

Johnson studied 402 months of gridlock -- defined as a president of one party and both houses of Congress controlled by the other party – and 270 months of what he calls political harmony, in which all three institutions were controlled by the same party.

"The rationale for the 'gridlock is good' conventional wisdom is that gridlock reduces economic uncertainty because it lessens the chance for significant legislative change," Johnson says. "People buy into that theory, because it fits nicely into a cynical view of government."

Johnson and two colleagues found that stock market returns for the largest companies were about the same -- a little more than 8% -- over the period 1949 to 2004. Small cap stocks, however soared 27% during periods of harmony, compared with a miserly return of just under 5% in times of political gridlock.

Johnson cites the recent example of the Dow, which climbed about 40% during the first two years of the Obama Administration -- a period when the Democrats controlled Congress as well as the White House. During the last two years of the Bush administration, with a Democratic-controlled Congress, the market rose by 36%.

Division Is Divine

But that's not always the case, says Jeffrey Hirsch, editor-in-chief of the Stock Trader's Almanac. According to Hirsch, the gridlock combination of a Democratic president and a Republican-controlled Congress produced the best-ever result: a 19.5% annual average increase. All six of those years were under President Clinton in the late 1990s. Under President Reagan, gridlock did pretty well, too. The market was up an average of 12.9% over six years, when the Congress was split between a Democratic House and Republican Senate. In four of those years, the Dow was up by 20%.

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The truth may be that gridlock or political harmony actually plays a smaller role than many believe. Johnson says he did a separate study that showed the market was more closely connected to interest rate policy set by the Federal Reserve. When Fed policy is loose, the market tends to head higher, and when it's tight, the market often tumbles, he says.

"From a portfolio standpoint, I would worry less about who is in control, because the Fed is a heckuva lot more important than the political situation," Johnson says.

He adds that the Fed is often most expansive in the third year of a presidential term because the midterm elections are over and the ensuing presidential campaign has not yet begun, so the Fed can appear to be above the political fray.

"Atypical Times"?

But there is one area where both experts find agreement. Hirsch says the third year of a presidential term is often the best, because that's when "politicians do things to get reelected, which puts money into the system and drives the market higher."

Before you wager your life savings on the market next year, however, consider this: Johnson believes an unprecedented amount of stimulus money has been pumped into the economy in the last two years, and that may change the way things work.

"I think we're in atypical times, and I wouldn't expect that the past relationship is going to hold," he says. The market in 2011 may indeed defy attempts to predict its course with statistics. The best bet is probably to avoid gambling on such flimsy evidence.