Markets Prepare for Congressional Shake-Up

Nov. 7, 2006 — -- Though the first official ballots in the midterm elections weren't counted until Tuesday evening, Wall Street has been counting on the outcome for weeks.

Ever since Democratic strategist James Carville coined the maxim, "It's the economy, stupid!" during the 1992 presidential election, money matters have been at the forefront of the electorate's mind when voters headed into the voting booth.

According to that thinking, the economy's recent solid performance under the watch of the Republican-controlled Senate, House and White House would seem to have suggested the Democrats were in trouble.

But it didn't play out that way.

Democrats took control of the House of Representatives and awaited word early Wednesday on Senate races in Virginia and Montana to find out if they will also take over the Senate.

This year, despite a solid economy with low unemployment and relatively good growth over the past three years, prognosticators aren't bullish on the outlook for the Republicans. The war in Iraq and a string of Republican scandals translated into a big turnout for Democratic candidates.

The smart money on Wall Street has already started moving, even before the election.

Pharmaceuticals Could Take a Hit

Perhaps the best place to see all this dollar-backed Wall Street pre-election "voting" is in the pharmaceuticals industry.

The Amex Pharmaceuticals Index has dropped 3.3 percent in the past seven trading days as investors bet that a Democratic House would move quickly to change the Medicare Part D drug benefit that would give government buyers the power to negotiate lower prices. That would likely erode industry profits by tens of billions of dollars in the next few years.

Experts say the profits in the utilities sector will also likely take with the Democrats' win, thanks to an increase in clean air regulation that will cut into profits at coal-fired generating plants.

Analysts say some sectors could reap financial rewards if the Democrats gain control of at least one house of Congress.

Mortgage giants Fannie Mae and Freddie Mac came under fire from Republicans, as regulators became increasingly concerned about the size of their massive portfolio of mortgage loans. Congress has pushed for increased regulation of the two government-sponsored entities.

A Democratic-controlled Congress would likely put those regulatory issues on the back burner, and the stocks reflect that. Fannie Mae shares are up 7 percent in the past month, and Freddie shares have grown more than 4 percent.

These government-sponsored entities are generally less philosophically offensive to the Democrats. Republicans tend to see them as overstepping the public-private boundary -- government doing something that the private sector could do.

Analysts told ABC News that alternative energy companies -- firms that build solar, wind and bio-fuel technology -- are also likely to be winners in a world where Democrats control at least one house of Congress. Democrats are expected to try to update the Clean Air Act, providing government incentives to research and deployment of noncarbon energy sources.

Split Power Doesn't Have to Be Bad for Business

With President Bush entrenched in the White House for another two years, Republicans will maintain executive control regardless of Tuesday's outcome. And that might not be a bad thing for the business world.

Jeff Kleintop, chief investment strategist at PNC Wealth Management, said that a tug of war between the legislative and executive branches of government prevents major changes in policy and spending that could alter the business environment.

"It has generally been good to have a split government," said Jeff Kleintop, chief investment strategist at PNC Wealth Management. This thinking is based on a widely held Wall Street belief that a split government can't do anything because of a political tug of war -- can't overspend and can't enact laws and regulations that are unfriendly to business.

Bonds Could See a Boost

It's not just stocks that will be affected by Tuesday's elections. The bond market usually enjoys a boom with two-party government.

"It's historically been very good for the bond market, in that sweeping spending initiatives are a lot less likely to be passed, thus making big debt issuances highly unlikely," said Kleintop.

Analysts were also confident that the capital gains tax cuts passed in the first years of the Bush presidency would not be repealed. Coupled with the strong bond market, you have a recipe for relative strength on Wall Street during the next two years, with some winners and some losers.

"I think that the Bush tax cuts don't get resolved until after the next presidential elections," Laperrier predicted. "There's not going to be a meaningful change in fiscal policy. And so there's no macroeconomic implications from the election results."

But not all the experts agree that history is a good guide to the future.

"Democrats long shut off from effective dissent could take the opportunity to investigate the president, the war, Donald Rumsfeld and all-but water board Dick Cheney," said Bob Brusc, a self-proclaimed politically neutral economist for FAO Economist, in a note to clients.

Should the Democrats aggressively investigate the current administration, a change in Congress could actually be bad for bonds as foreign investors -- huge buyers of U.S. debt -- lose confidence in the U.S. market.

If our neighbors overseas stop sending their savings to the United States for Americans to spend, it could be bad news for the global economy. The American consumer's unabated spending during the past five years has driven economic growth across the globe.

A quick change in our heavy-spending ways could quickly tip the world into recession, spelling political and economic trouble for everyone, no matter what their political affiliation.