Tuesday, November 7, 2006

Will Ballots Favor Bulls or Bears?

News Analysis
November 7, 2006

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Will Ballots Favor Bulls or Bears?

Markets have largely priced in a Democratic takeover of the House, analysts say. But stocks could move if the midterm elections become a rout

As time ticked down to the first polls closing at 6 p.m. Eastern time, investors were gearing up for the prospect of Democratic gains in the midterm congressional elections on Nov. 7 (see BusinessWeek.com, 11/7/06, "Your Midterm Elections Scorecard"). Fundamentals should continue to drive market action over the long run, but a surprise in tonight's results could carry a short-term impact, analysts say.

The Iowa Electronic Markets were offering strong odds that Republicans will lose control of the House of Representatives but hold onto the Senate. In afternoon trading, prices on this University of Iowa futures market for betting on election results suggested an 82% chance Democrats will win the House and only a 31% chance Republicans would lose the Senate.

Wall Street analysts were also predicting a divided Congress. While some view gridlock as a positive, others note that a unified government has historically produced better stock returns (see BusinessWeek.com, 11/3/06, "Preferably, It's All or Nothing"). Either way, an unexpected Democratic sweep of both chambers could rattle the markets in the immediate term.

Democratic Sweep May Worry Investors

Stocks were higher ahead of the election results on the afternoon of Nov. 7, as the Dow Jones industrial average flirted with a new all-time closing high. "It looks like the market's gotten past the notion of a split Congress and is currently rejoicing in gridlock," says Jack Ablin, chief investment officer at Harris Bank, noting that divided leadership could help the markets avoid interference from legislators. "While there are certainly some longer-term implications for the stock market, the near term has probably brightened."

However, investors might not react as kindly to a surprise. A substantial Democratic victory in the Senate, as well as the House, might provoke a brief sell-off, according to Ron Brown, chief investment officer at Genworth Financial Asset Management. "The market could use that as an excuse to have a hiccup," Brown says.

The effects of a Democratic sweep would likely reveal themselves on the sector level, rather than across the broad market, some analysts say. Investors might be worried, rightly or wrongly, about possible Democratic legislation hampering health-care companies, defense contractors, or Big Oil, says Brian Gendreau, investment strategist at ING Investment Management.

Meanwhile, a divided government might not be as bullish as some investors hope, other analysts say. "Gridlock is a positive if there's nothing that needs to be done," says Barry Ritholtz, chief market strategist at Ritholtz Research. "We're in a situation where there are a lot of issues that should be addressed sooner rather than later."

Spin Could Affect Stocks

Ritholtz also raises the possibility of Democrat-led congressional investigations into the Bush Administration's actions. He says a "drumbeat" of allegations relating to prewar intelligence or Halliburton (HAL) could set a gloomy backdrop for stocks.

At the same time, both parties will be battling to spin the election results in the most positive light. Democrats will be looking to claim a mandate, while Republicans might portray a narrower-than-expected Democratic triumph as a Democratic defeat, says George Schwartz, president of Schwartz Investment Counsel, which runs the Ave Maria Funds. Democratic success in this war of spin could raise worries about tax rate hikes, he says, while stocks could rise if the GOP can claim victory.

Overall, though, analysts stress that economic indicators, corporate profits, and other fundamentals will likely continue to determine the direction of the markets, regardless of which political party runs Congress. "The most we face is perhaps a transitory surprise that probably would be remarkably short-lived," says Genworth's Brown. While Wall Street's long political guessing game may be about to come to an end for another year, the votes will have to be counted first.

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