Democratic House No Pox on Stocks

By Liz Rappaport, Markets Columnist
TheStreet.com

Like the Montagues and the Capulets of Shakespeare's Romeo and Juliet, the two houses of Congress are likely to be at odds with one another after the midterm elections in November.

The latest Wall Street Journal/NBC poll, released Thursday, shows voters prefer that Democrats rather than Republicans control Congress by a 52% to 37% margin, the widest spread in the poll's 17-year history. The poll also reveals anti-incumbent sentiment matches the levels hit in 1994, when Republicans took control of Congress for the first time in 40 years.

The ensuing rancorous gridlock may make for ugliness in Washington, but its impact on the stock market will likely be superficial. Controversial or sweeping reform will probably take a back burner to industry-specific embarrassment and headline risk.

In other words, no plagues on the house of Wall Street.

"The idea of gridlock is not a problem for the market, because it means nothing of real import disturbs the business environment," says Tobias Levkovich, chief U.S. equity strategist at Citigroup. "Businesses can adjust to minor disturbances."

At present, a Democratic win in the House of Representatives is largely priced into the stock market, which has rallied to new highs through the campaign process thus far. Futures markets put the likelihood of a Democratic takeover, or at least 15 net wins in the House, at 63.1%, according to InTrade.

Odds of a Democratic takeover in the Senate have been increasing of late, but remain at 32.6%, according to InTrade. In the Senate, the Democrats must win a net six seats to gain control.

The biggest play on a Democratic win in the midterm elections are mortgage financiers Fannie Mae (FNM) and Freddie Mac (FRE), say analysts.

With the Democrats in power, these government-sponsored enterprises that facilitate home ownership may be more insulated from criticism. Their shares have rallied 25% and 19%, respectively, since mid-August, as prospects for Democratic gains took hold.

Such big gains for the GSEs show that investors have begun discounting change of at least control of the House, even if they're not making big bets elsewhere to reflect such a change, writes Charles Gabriel, political analyst at Prudential Equity Group in Washington.

So the market buys the Congressional shift, but worries less about the results.

Marquee issues Democrats might love to address -- including rolling back the Bush tax cuts or pulling troops out of Iraq -- don't have a snowball's chance in Texas of getting through a Republican Senate, much less avoiding the President's veto.

Likewise, marquee issues for the Republicans, such as Social Security reform and making the tax cuts permanent, are equally unlikely to be addressed.

But there is good gridlock and bad gridlock, warns Gabriel.

Bad gridlock happened in the 1980s when the economy needed rebalancing, he points out.

Counter that with 1990s gridlock, which was "blessed" because tax revenues were surging and the tech bubble inflating. "The sense is that now we have something in the middle," Gabriel says.

Indeed, the economy is slower after the Federal Reserve raised the fed funds rate to 5.25% from 1% in July 2004, but consumers are still spending, the job market is tight and tax receipts are strong.

The gridlock leaves the House with the power to push some less dramatic legislation through, like a minimum wage increase, prescription drug price reform and possibly net neutrality regulation.

But Democrats greater power may be in their bark, rather than their bite.

"Every week there will be a hearing to embarrass some sector," says Greg Valliere, chief strategist at the Stanford Washington Research Group.

Democratic committee leaders would likely have hearings to bring to the fore industry practices and privileges that have been swept under the rug with Republicans in power.

Therein lies the headline risk, says Valliere. Without hard-hitting legislation, however, the Democratic control means more risk to those Republican-protected industries, and not much reward for Democratic darlings.

Energy on the Hot Seat

Don't expect windfall profits legislation, but the oil industry will likely be marched in for more hearings.

This could be unpleasant for the big oil companies like Exxon Mobil (XOM), BP (BP) and Occidental (OXY).

Similarly, environmental hearings could hurt coal companies, auto companies and heavy manufacturers.

On the other side, such hearings could benefit companies involved in developing alternative energy solutions, including Evergreen Solar (ESLR) and Pacific Ethanol (PEIX), as well as agricultural companies such as Archer Daniels Midland (ADM).

The biggest bark of a Democratic House could bite big pharmaceutical companies like Merck (MRK) and Pfizer (PFE).

Analysts expect the Democrats to push legislation allowing the government to negotiate with pharmaceutical companies on prices of prescription drugs for Medicare beneficiaries.

On the flip side, generic drug companies like Teva Pharmaceuticals (TEVA) and health care technology companies could benefit from the bill.

Another hot topic in Washington is so-called net neutrality regulation, which would keep Internet service providers and infrastructure builders like telecommunications and cable companies from charging content providers for transmission.

Otherwise the network providers could create tiered levels of transmission, like overnight shipping vs. regular mail.

Democrats favor the regulation, would benefit Internet giants like Google (GOOG), Yahoo! (YHOO) and eBay (EBAY).

Even debate over net neutrality could put a dent in the network providers, as a potential revenue stream could be wiped out before it even began for companies facing already limited growth potential.

Companies like Time Warner (TWX), Cablevision (CVC), AT&T (T)and Verizon (VZ) stand to lose.

Turning over rocks in the foreign policy fields could hurt some defense contractors like United Technologies (UTX) and Halliburton (HAL). But others, such as General Electric (GE), might benefit from more freedom to bid for the contracts they have heretofore been blocked from.

However, don't expect Democrats to make overarching cuts to defense spending, as they need to prove their might when it comes to homeland security ahead of the 2008 Presidential election, says Valliere.

So as the third act opens on the Bush Presidency, the midterm elections and gridlock make the ending seem anticlimactic.

But the guns are certainly in the drawers, as a Democratic House and a more Democratic Senate could raise issues and policy questions that will become central to the next Presidential election.

The market's reaction is likely muted near term, but the stage is set for some high drama as the calendar marches toward 2008.

Back to Beat the Market: Your Money and the Mid-Term Elections