Thursday, September 21, 2006

A Game Plan for D.C. Gridlock

News Analysis
September 21, 2006

A Game Plan for D.C. Gridlock

Analysts think Democrats may win one or both houses of Congress in November. Here are some investment strategies to cash in on a divided government

Wall Street could soon be eyeing some unfamiliar faces in Washington, D.C. In recent reports, Goldman Sachs and Prudential both say the odds favor Democratic gains in the Nov. 7 Congressional elections, possibly including a shift in leadership at the House of Representatives. While it's too early to count the Republicans out, it still might be a good time to prepare for the legislative alternative.

Democrats have their eyes on more than three dozen vulnerable Republican Congressional seats this fall, while only 10 or fewer Democratic districts are in the GOP's reach, according to Prudential Equity Group's political analyst Charles Gabriel. "We are raising our odds of the Democrats' retaking the House of Representatives to 55%, while maintaining our one-in-three odds of a Senate takeover," Gabriel said in a Sept. 5 report.

The latest polls have picked up a bit for Republicans, but their electoral outlook remains unclear. The most recent USA Today/Gallup poll showed President George W. Bush's approval rating at 44%, a slight increase from 42% in August. In Congressional races, the same poll showed a generic Republican and a generic Democrat in a dead heat.

An increasingly Democratic Congress won't alter the basic economic and earnings trends that drive the stock market, but it could have implications for a few sectors and stocks. This week's Five for the Money looks at strategies investors can use to benefit should Democrats retake one or both houses of Congress.

1. Stay on the defensive.
Next year should be a crucial time for investors who follow presidential election cycles. The third year of a President's term in office, whether it's his first or second term, has historically been the strongest for the stock market. Since 1945, the Standard & Poor's 500 index has posted an average annualized gain of 18% during such periods, compared to 9% for all years.

This year could be an exception, some analysts say. "Usually in the third year of a President's term in office, he tries to put forth some sort of legislation that will be stimulative for the economy and therefore increase the chance that either he or his party will get reelected," says Sam Stovall, chief investment strategist for S&P Equity Research. Given low poll numbers and a potentially divided Congress, "I question what kind of stimulative package [Bush] could offer," he adds

A lack of catalysts for a strong third-term year is yet another reason investors should keep a cautious stance, according to Stovall. Regardless of which party controls Congress, investors should stick with high-dividend, high-quality stocks, he says (see, 7/28/06, "Quality Time?").

2. Check your prescriptions.
Wall Street typically views the health-care sector as the most politically sensitive segment of the stock market. Much of the industry's revenues are linked to government programs, such as Medicare. For instance, the new Medicare prescription drug program could provide opportunities for host of companies, from drugmakers Pfizer (PFE) and Johnson & Johnson (JNK) to insurers UnitedHealth Group (UNH), WellPoint (WLP), and Humana (HUM) (see BusinessWeek, 1/30/06, "Plan A: Hook Them with Part D").

With so much riding on politics, some analysts worry what a change in House leadership would mean for such stocks. "Prospects of major Democratic gains may pressure health care," Goldman Sachs (GS) strategist David Kostin says in a Sept. 5 report.

However, others say any effect would be mostly psychological—and could represent a buying opportunity. "Our studies have shown that pre-election underperformance is often matched by post-election outperformance in health care," says Jack Ablin, chief investment officer at Harris Bank. "The impending election could create some compelling values in this attractively ranked area of the market."

Merrill Lynch analyst Brian Belski, who has a market-perform recommendation on the sector, makes a similar point. "We are increasingly enthused regarding longer-term earnings and valuation trends, which appear to have bottomed," Belski wrote in a Sept. 11 report. "While the sector will probably be a political target later this fall, we believe valuations (especially within growthier areas) could become more attractive as a result."

3. Don't count out energy.
Like health care, energy is another sector likely to suffer negative headlines in the event of Democratic Congressional gains. Leading Democrats favor more environmental regulations to limit the emission of greenhouse gases, which could affect fossil fuel companies from Exxon Mobil (XOM) to Peabody Energy (BTU).

Many Democrats support the Kyoto climate change treaty, which former President Bill Clinton's Administration signed but which Republicans, including Bush, have opposed. More recently, former Democratic Presidential nominee Al Gore has called for an immediate freeze on carbon-dioxide emissions. "A Democratically controlled Congress would probably be much more likely to pass environmental safeguards, which would affect any number of industries," says Brian Gendreau, investment strategist at ING Investment Management.

Energy stocks have already taken a hit in recent weeks. As of afternoon trading Sept. 20, the Vanguard Energy ETF (VDE) has shed 10.4% since Aug. 25. Crude futures have tumbled near six-month lows amid fading worries over geopolitical tensions and hurricane season (see, 9/11/06, "Will Oil Stay Soft?").

Still, energy could follow healthcare in performing better than investors might infer from Democratic gains. Global unrest and overseas demand both remain high, which bodes well for energy prices, according to Goldman Sachs' Kostin, who has a bullish stance on the sector. The oil and gas equipment and services sub-sector is particularly poised to outperform, Kostin says.

4. Watch for a wage hike.
Could it be time for a raise? It has been nine years since Congress last raised the federal minimum hourly wage, currently set at $5.15. Most Democrats in Congress support increasing the minimum wage, while Republicans have sought to tie any wage hike to estate-tax cuts. A bill passed by the House in July has yet to reach the President's desk.

Democratic gains in November could change the political calculus. "It seems that companies with a large contingent of U.S.-based low-wage workers are facing a significant increase in their labor costs," says Thomas McManus, chief investment strategist at Banc of America Securities (BAC), in a Sept. 5 report. The U.S. Chamber of Commerce and the National Restaurant Assn. are among business groups opposing a wage hike.

Still, the effects of a federal minimum wage hike might be smaller than some fear, McManus notes. Entry-level pay at big-box retailers, for instance, is often already above the lowest rate, and Wal-Mart (WMT) has called on Congress to raise the minimum wage. Meanwhile, 17 states have minimum wages above the federal mandate, and several states have increases in the works, including California.

5. Remember, it's only politics.
In general, divided government can be a positive for the equity market, analysts say. "You'll have a situation where you're not going to get much done," says Peter Cardillo, chief market analyst at SW Bach. "Sometimes gridlock is good for the markets." Just look at stocks' gains in the 1980s and 1990s, when President Ronald Reagan and Clinton each squared off with a legislative branch led by the opposing party.

It's also difficult to predict the effects of any possible Congressional investigations into the war in Iraq or other hot-button issues. "The Democrats don't have to take both houses of Congress," says Barry Ritholtz, chief market strategist at Ritholtz Research & Analytics. "All they need to do is obtain one house, which then generates subpoena power, and at that point they're pretty much reinvestigating everything."

While the upcoming election could jostle a few stocks here and there, it's no reason to overhaul an entire portfolio. While politicians nervously glance at day-to-day poll numbers, investors should stay focused on what's best for the long term, market watchers say.

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