Returns Are Lower During Gridlock

With a big mid-term election coming up on Tuesday, I figured I'd do a politically-themed post.

It seems the prominent view that gridlock is good for the stock market is one that continues to be held by big investors. In this weekend’s Barrons, the cover story indicates that a common theme now being echoed among "big money" investors is that gridlock is good for the stock market. This is a belief that many hold, but one which has been called into question by a recent study published in the Financial Analyst’s Journal.

Gridlock is considered to be the state of government where the Senate, House, and Presidency are not held by the same party. The thesis behind “gridlock is good” for the stock market is that fewer legislative changes will take place in this situation, which reduces economic uncertainty.

The popular press has mentioned the “gridlock is good” argument fairly consistently, it seems without the proper data to back it up. The study I mentioned provides evidence that a government controlled by the same party – what they call “political harmony” – has enjoyed higher equity returns with lower volatility than during periods of gridlock. "Harmony” returns have been from 22% higher for the smallest companies to 0.5% higher for the largest companies - versus periods of political gridlock.

Furthermore, the study shows that the smaller-company “premium,” where small cap stocks have historically provide higher annual returns than large cap stocks, occurs in periods of political harmony (up 27.03% versus 4.65% in gridlock), and that large-cap stocks have actually outperformed smaller ones during periods of gridlock by nearly 4% annually. These results are independent of monetary conditions that existed during these periods, so they are significant.

On the other hand, the study found that fixed-income returns and volatility were higher during periods of political gridlock. This was mainly the result of interest rate changes during these periods.

I find it fascinating when a long-held, ubiquitous belief is shown to be wrong. This illustrates why its important as an investor to know why we hold the beliefs that we use in making investment decisions. They could very well be unfounded, or worse yet, wrong.