Divided government: a mixed blessing for stocks

Democratic victories in the 2006 mid-term elections have given the party control of the House and Senate, ending a period of sole Republican rule that began in 2003.

Consulting Group senior writer Bill Montague examined the change in powers and the markets in a recent report. I have extracted some points of interest. Some investors and analysts have greeted these results with optimism, arguing that divided government - in which different parties control the presidency and Congress - is more constructive for the stock market.

The reasoning: Divided control forces both parties to compromise, curbing partisan excesses - such as new regulations or runaway deficits spending - that might damage the economy and equity valuations.

As proof, some analysts cite the experience of the late 1990s, when the Republicans controlled Congress and Democrat Bill Clinton was in the White House. The two sides were able to balance the budget, reform welfare, approve several major free trade agreements and take major steps towards deregulating the banking, utility and telecommunications industries.

Result: one of the most powerful bull markets in stock market history.

The story is attractive, but reality is more complex. Divided government can encourage compromise, but it can also lead to partisan paralysis and an obsession with scandals both large and small. Under such conditions, finding solutions to long-term problems-such as rising health care and Social Security costs-may be harder, not easier.

It's also easy to exaggerate the influence that politics and politicians have over the stock market. Government control of the economy has been eroding for the past several decades, and few in either party advocate a return to the more meddlesome policies of the past. What's more, the most influential government agency of all - the Federal Reserve - is specifically designed to be insulated from political pressures.

So is divided government better or worse for stocks? To shed more light on this issue, we looked at the market's historical performance under both divided and unified party control going back to 1925 - the period covered by the S&P 500 Index and its predecessor benchmarks.

During that time, one party has controlled both chambers of Congress and the White House for a total of 44 years - or just over 54 percent of the time. Control was divided, with one party in charge of at least one house of Congress and a different party holding the presidency, for just under 37 years- or just under 46 percent of the time.

During divided-government periods, the S&P 500 Index posted a cumulative, annualized return of 9.03 percent. This was actually somewhat lower than the 11.57 percent annualized return for periods in which both branches of the government were in the hands of a single party. (Annualized returns make it possible to compare time periods of differing length.)

It's important to note that returns have varied greatly from one political era to the next. In reviewing the annualized returns for each distinct period of divided or single-party rule since 1946, there appears to be little consistency to the pattern. Returns for periods of divided government have ranged from an 18.9 percent loss to a 21.3 percent gain. Likewise, returns in periods of sole party rule have been as low as a 10.2 percent loss and as high as 23.1 percent.

Given this volatility, and the small number of examples the differences in market performance may not be statistically significant- in other words, they may be the product of chance.

But it's possible that poor stock market performances may lead to periods of divided government, instead of the other way around.

The seeming frequency of bear markets during periods of divided government could also be a possible statistical illusion. However, the historical record at least suggests that bad economic conditions, civil unrest or war weariness can have a negative effect on both the stock market and the party in power - enough to knock them both for losses.

Based on just the historical record, it's impossible to predict how the stock market will react to the recent election and the return of the Democrats to congressional power. Other factors, such as Federal Reserve policy, energy prices and - not least - the underlying strength of the economy are all likely to play a more significant role.

The record does suggest, however, that investors who alter their long-term investment strategy in response to short-term political changes could be disappointed with results. Market advances and declines have occurred under both parties, and under both divided and unified control. Using the election results as a buy or a sell signal could end up being a good way to miss the next move up - or catch the next move down.

That's why for most investors, developing a sound, diversified portfolio strategy and sticking to it remains the most prudent investment approach.

For more information, e-mail william.a.creekbaum@smithbarney.com or call 689-8700.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial-services firm serving Northern Nevada at 6005 Plumas St., Ste. 200 Reno, NV 89509.