November's election has come and gone, and with it so has Democratic control of the House of Representatives. Normally, government gridlock is extremely good for stock market investors, based on looking at real investment returns after inflation. Using gold as a deflator (not the CPI) back to 1973, and total return on the S&P 500, investors have had yearly real returns of 15 percent on average for all split governments, and yearly real losses of 10 percent when government is unified with the same party controlling the House, the Senate, and the Presidency. For example, the S&P 500 Index is up 35.7 percent from the end of 2008 through Nov. 5, 2010, but gold is up 61.3 percent, so investors are losing about 10 percent annualized in real terms with unified government. In fact, since 1973, gold has gone up at an annual rate of 28.8 percent when government is unified, which explains in part its recent giant rally. Conversely, when government is split, gold has gone up at an annual rate of only 3.4 percent, which suggests it's best to be careful about this rally, at least in the short term.
The Ratchet
Even though the historical record for gridlock is great, history may not repeat itself in the near term because there is a difference between benign gridlock, when economic times are “normal,” and malignant gridlock, when they are not. Our economic crisis may be aggravated by having Congress itself split and the growth in government subject to a ratchet. While Reagan had a split Congress and a fabulous run, Hoover had a split Congress during his last two years, and the market lost 63.4 percent. In crisis times, a Congress that cannot undo its mistakes is not good. The United States had in some ways more relative positives then than we do now, and the market still suffered enormously. For example, the dollar was strong, we were net creditors to the world, and government was a relatively small component of the economy.
That certainly isn't the case now. Against this background, some initial indications coming out of Washington do not appear to be favorable for seriously reducing the size of government, which is essential to long-term economic health. Fed Chairman Bernanke's Treasury is printing an additional $600 billion to fend off deflation, but Congress has yet to even produce a budget for this current fiscal year and may not even settle our tax rates until after the New Year. Even Nancy Pelosi is back as the leader of the Democrats in the House. If it turns out to be a “business-as-usual” Congress afraid of being branded “do-nothing” while the dollar is slipping closer and closer to a run due to excessive quantitative easing, it will not be good for real investment returns. The acid test of this Congress will be whether it can rein in spending and drastically reduce our borrowing and regulatory burden. We now face a liquidity trap, where additional injections of money into the economy fail to stimulate demand. Interest rates cannot be reduced below zero, although we are trying to do that with TIPs. A key driver of this liquidity trap is what I would call the “regulatory trap” where government harbors the illusion that additional regulations have no cost. In fact, some have estimated the regulatory drag on the economy at roughly $2 trillion. Think of the regulatory drag as deflationary because it freezes business and Bernanke's Fed as inflationary, and you will understand better why we're all feeling so bipolar.
To give you some perspective, I believe Sarbanes-Oxley was the main straw that broke the back of small business job growth in the United States. This totally bipartisan law had only 16 regulations. Passed in 2002, it became an important factor in systemically raising unemployment from 5.9 percent at the bottom of that recession to 9.6 percent last month. Between health care, the EPA and financial regulation reform, there are over 1,400 new regulations in the pipeline. The American investor is like a skier at the base lodge watching an avalanche start at the top of the mountain. Who can be optimistic that this Congress can stop the regulatory avalanche, or get control of our budget or our debt? There are just too many permutations and too many opportunities to play good cop, bad cop, and really bad cop. It's not your father's gridlock.
Eric Singer, principal of Congressional Effect Management, runs the Congressional Effect Fund (CEFFX). For more, see congressionalfund.com.