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An Investment Guide to the Midterm Elections

What would a divided government mean for stocks and bonds?

Forget politics. Before you cast your ballot in November, think how it will affect your portfolio. Some on Wall Street expect the stock market to benefit if the Democrats gain enough seats to take control of the House of Representatives. The linchpin of this idea is that political gridlock is good for stocks. A Congress divided between a Democrat-controlled House and a Republican-run Senate and White House reduces the chance that lawmakers will upset the legal and regulatory status quo.

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Good story, but historically speaking, it's a myth, says Robert Johnson, managing director at the CFA Institute. He and finance professors Scott Beyer and Gerald Jensen studied stock and bond returns from 1949 through 2004 during periods of "political gridlock" and "political harmony" and found that stock returns were higher and less volatile during periods of political harmony. The professors considered a period to be harmonious if one party controlled the White House and Congress. If the parties shared power, the period was defined as one of gridlock.

But if bonds make up a big part of your portfolio, you may want to support Democrats this year, the study suggests. It shows that during periods of divided government, bonds generally beat stocks. Johnson and his colleagues conclude that gridlock does lead to a slowdown in legislation and to slower growth in spending. That should mean smaller budget deficits, which means the government needs to issue less debt. That could lead to lower interest rates, and since bond prices move inversely with yields, bond holders tend to benefit.

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Recent history tells a different story about gridlock, however. Since 1980, stocks gained more than bonds in periods of so-called political gridlock and in times of one-party control.

Yet, midterm election years do matter to the stock market. Sam Stovall, chief investment strategist at Standard Poor's, finds that, on average, the second and third quarters of the second year of a president's term -- when midterm elections take place -- produced the worst returns in the SP 500-stock index during the four-year presidential cycle. Stovall gives some examples of the phenomenon: The 2000-02 bear market bottomed in the third quarter of 2002, the second year of President Bush's first term. In 1998, the second year of President Clinton's second term, the hedge fund Long Term Capital Management melted down and the stock market plunged 14% in August of that year.

But this year's third quarter bucked Stovall's trend. The May-June correction dinged many portfolios, but the market recovered. Stovall thinks third-quarter performance was better than expected because energy prices have eased, the Federal Reserve ceased raising interest rates, and many on Wall Street predict a soft landing for the economy.

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Regardless of historical trends, many market watchers are gung-ho on stocks partly because of the political gridlock effect. "If there's gridlock, the chances of unwinding conditions we consider favorable are diminished," says David Joy, chief market strategist for RiverSource Investments. Such conditions include favorable tax rates for capital gains and dividends. Joy says it's also less likely that a divided Congress will pass protectionist legislation that could choke global trade. Such a trend would hurt retailers and other companies that depend on overseas goods.

You might be too late if you want to tweak your portfolio for the midterms. The market, which tends to anticipate the future, already has priced stocks with the expectations that the Democrats will make some gains in Congress, says Joseph Quinlan, chief market strategist of Banc of America Capital Management. If the Democrats take over both chambers, that's another story. In that case, stocks in the energy and health care sectors could drop, Quinlan says, because a Democrat-controlled Congress would be more inclined to pile additional regulations onto those industries.

Like all aspects of market forecasting, election-year punditry is more art than science. So don't rush out and reshuffle your portfolio based on political polls. It's better to have a consistent investment plan and stick with it no matter who is in power.

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