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There’s a lot of discussion on Wall Street about the positive impact on stocks if there is gridlock in Congress.  The idea is that Obama’s anti-business, big government, tax the rich administration will be forced to move more towards the center and that means a more business friendly environment.  Unfortunately, it’s a bunch of nonsense – particularly in this environment.  Fidelity Investments ran the numbers and found that there is no positive correlation between  mid-term elections and gridlock:

“The theory that inaction caused by political gridlock—where the U.S. Senate, U.S. House of Representatives, and White House are not all controlled by the same party—is often considered “good for the market” does not appear to have much historical support from stock-return data following midterm elections. Large-cap stock returns during post-midterm election years have been about the same, whether or not the outcome resulted in gridlock or harmony (i.e. one party controls both houses of Congress and the White House). Small-cap stocks, meanwhile, outperformed in years of political harmony compared to gridlock.”

Stocks, it seems don’t care who is in office during the year after a mid-term election.  They have tended to rally in the third year of the presidential cycle no matter the make-up of government:

“U.S. midterm elections typically have kicked off a period of strong gains for U.S. stock investors. Consider the period from 1950 to 2009. During the year after a November midterm election, average annual returns for large-cap stocks were 23.4%, more than twice the 11% average from 1950 to 2009. Likewise, small-cap U.S. stocks returned 31.2% versus the long-term average annual returns of 13.5%.”

Of course, there’s a caveat here.  This isn’t your average economy.  The period between 1950 and 2009 was unusually calm.  There were no major financial crises, the US economy grew steadily and aside from a few multi-year bumps in the road there was nothing devastating of the magnitude similar to the current crisis.

As of yesterday the Intrade contract for the Republicans winning the House was at 83%.  This contract has been on a tear as 2010 has progressed and economic conditions have remained weak:

The contract for the Republicans winning the Senate is less decisive, but also on the rise at 45.7%:

Based on this data it looks highly probable that gridlock is coming to Washington.  Unfortunately, that likely means that we won’t get much done in the coming two years as the Republicans will be anti spending and hesitant to give Obama any major economic victories that he can promote in 2012.

The problem with gridlock in this environment is that government steps entirely out of the picture.  Now, we can quibble over whether that is a long-term positive or negative, but one thing is clear – over the last 18 months government has done an enormous amount to keep this economy from sinking into the abyss. That positive effect is turning into a negative effect as we speak:

What does it all mean?  It means the private sector is going to have to remove the training wheels and see if they can right this economy without the aid of government.  With the likelihood of continuing de-leveraging, high unemployment, stagnant economic growth and no government aid the likelihood of gridlock being a net positive in 2011 and 2012 is low at best.

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