Caution: Political Gridlock Could Spell Trouble this Time

Fearing needless meddling from politicians in Congress, market veterans typically believe in the maxim that gridlock in Washington is good for stock prices on Wall Street.

Yet with the countdown to the manufactured fiscal cliff ticking, investors and corporate executives are now clamoring for the opposite of gridlock: immediate action.

History shows that congestion in Washington is actually rarely good for equities anyway as the S&P 500 grows twice as fast when a single party controls both the White House and Congress.

“Unfortunately since Congress can hold American business hostage…rather than leading, they end up impeding,” said Sam Stovall, chief market strategist at McGraw-Hill’s (NYSE:MHP) S&P Capital IQ.

The highly-anticipated 2012 election resulted in the return of the status quo as Democrats held onto the White House and the two parties split the House of Representatives and Senate.

The split control makes it much tougher for politically-difficult legislation (like a long-term fix to the   country’s debt mess) to make its way through Congress and avoid the veto pen of the executive branch.

Even in years when the ominous fiscal cliff isn’t threatening economic growth, divided government seems to slow down Wall Street.

According to S&P Capital IQ, since 1901 the S&P 500 has gained an average of just 3.7% when Congress is split, compared with 6.2% in a unified Congress and 7.6% when the entire government is controlled by one party.

There have only been a dozen years of this gridlock scenario, including the past two years when the S&P 500 has climbed an average of 6% with President Obama in the White House.

By comparison, the broad index has generated a more modest increase of 3.2% in the 10 years when Republican presidents contended with a split Congress, S&P said.

Stovall said the belief that gridlock is good partly stems from an “anecdotal assumption: If Congress can’t agree on anything, then they can’t burden us with regulation and taxes and therefore it’s got to be good.”

In reality, Wall Street has enjoyed the strongest growth when one party controls both the White House and Congress. S&P said the S&P 500 has rallied an average of 7.6% in the 66 years of this unified government scenario; 8.4% under Democrats and 6.4% under Republicans.

The current situation is muddied by the need for both sides to strike a deal before the year-end fiscal cliff, the $600 billion batch of spending cuts and tax hikes that forecasters warn could send the U.S. into a painful recession.

“For the sake of future economic growth and the health and wellbeing of the next generation, Washington needs to break the impasse of recent years and make some decisions. Because this time around, gridlock will not be good,” Scott Wren, senior equity strategist at Wells Fargo Advisers (NYSE:WFC), wrote in a recent note.

A slew of corporate execs are scheduled to meet with the House GOP leadership on Wednesday to discuss the fiscal cliff, including Goldman Sachs (NYSE:GS) CEO Lloyd Blankfein, Caterpillar (NYSE:CAT) CEO Doug Oberhelman and Honeywell (NYSE:HON) CEO David Cote.

Wren said a good starting point for lawmakers searching for a compromise is the Simpson-Bowles plan, which called for about $3 in spending cuts for every $1 in tax hikes.

“We think the markets could live with that and would react positively if such a plan was adopted,” said Wren.

There is some hope that the election results and looming fiscal cliff will spark a bout of compromise: stock prices soared on November 16 after a positive-sounding appearance by Congressional leaders following a meeting with Obama.

Boosted by the upbeat sentiment in Washington and signs the global economy may be stronger than feared, the Dow Jones Industrial Average surged 421 points last week, its strongest weekly rally since June and best Thanksgiving week since 2008.

“It may be the season to be jolly, but if the rhetoric turns partisan and hostile again over the next few days, stocks could give back some of their recent gains,” Ed Yardeni, president of Yardeni Research, wrote in a note to clients on Monday.

Still, Yardeni said he is betting there will be a deal before time expires, potentially sending the S&P 500 to a new cyclical high.