What a Week: Politics Ambushes Rally

SAN FRANCISCO -- Wall Street long knew a setback was coming, so it had plenty of time to bake a cake. But as blue-chip stocks digested some of their recent gains this week, tech stocks continued to party.

For the week, the

Dow Jones Industrial Average

fell 2.6%, the

S&P 500

shed 1.1%, while the

Nasdaq Composite

gained 2.4%.

The week had a somewhat surreal feel, owing to widespread expectations for a decline, the absence of critical economic data, a slowdown in earnings announcements and anticipation of the long weekend (Wall Street is shuttered Monday in observance of Memorial Day).

Certainly, there was earnings news, including warnings from diverse companies, including

Ford

(F) - Get Report

,

ADC Telecommunications

(ADCT) - Get Report

and

Staples

(SPLS)

. Plus, significant

economic data were released -- including Friday's downward revision of first-quarter

gross domestic product

and sluggish durable goods report.

The data, plus separate

comments Thursday by

Federal Reserve

Chairman

Alan Greenspan

and

Fed governor Laurence Meyer contributed to Friday's setback, which occurred on the lowest trading volume of the year.

Both Greenspan and Meyer hinted the Fed may be closer to the end of its easing cycle, although Meyer seemed more concerned about inflation than his boss.

But, such issues did not hold sway over the stock market this week. Instead, investors eyed exogenous events such as

economic weakness in Europe and its impact on the dollar -- which soared this week, contributing to

gold's setback. Still, developments in Washington, D.C., proved to be the week's dominant event.

Politics, Politics, Politics

Late Tuesday, rumors began to circulate that

Vermont Sen. James Jeffords

was going to leave the

Republican Party

, tipping the balance of power back to the

Democrats

. Such scuttlebutt was as least partially responsible for Wednesday's setback, which ended the Nasdaq's six-session winning streak. Thursday morning, Jeffords

announced he was switching to an independent status -- aligned with the Democrats.

By week's end there were two main schools of thought on Wall Street: one, that Jeffords' switch would revive the gridlock in Washington that so well served Wall Street for much of the 1990s. Or, two, the

Bush

administration's agenda would be imperiled, putting at risk shares of companies in industries such as energy, health care, tobacco, defense and finance.

The Jeffords' switch is "extremely bad news for the stock market," declared Donald Coxe, chairman and chief strategist at

Harris Investment Management

in Chicago, in a conference call Friday morning. "One reason I was bullish was there was a chance of

the Bush administration getting a good part of its viewpoint into legislation/regulation. Well, has

that

ever changed, and

it can be seen in the price of stocks since Jeffords' announcement."

Indeed, many of the so-called "Bush stocks" stumbled: For the week, the

Amex Oil & Gas Index

fell 3.5% and

Philadelphia Stock Exchange Oil Service Index

shed 4.4%, while the

S&P Healthcare Index

fell 2.9%, the

Amex Tobacco Index

lost 3.3% and the

Philadelphia Stock Exchange/KBW Bank Index

fell 1.3%.

Meanwhile, defense contractors such as

General Electric

(GE) - Get Report

,

Honeywell

(HON) - Get Report

and

Lockheed Martin

(LMT) - Get Report

also retreated.

Weakness in those groups also could be attributed to investors' rising eagerness to own tech stocks. That, too, concerned Coxe, whose idea of being bullish is

less aggressive than most.

The market's technical indicators "continue to be terrific" but "we're back to the valuation problems, particularly in the Nasdaq," he said, expressing particular dismay that investors overlooked the dour semiconductor

book-to-bill numbers released Tuesday.

"The fact we did not destroy the optimism in tech means we're going to have to do it all over again

and have another major tech selloff," the strategist forecast. "Maybe this time we'll induce some real pessimism or realism in tech valuations. At these levels I can't be enthusiastic."

Coxe, long pessimistic on tech stocks, admitted he did not anticipate the group to lead in this latest rally. Nor did he provide a time frame for when that selloff might occur.

Charles "Chuck" Gabriel, a senior vice president and political analyst at

Prudential Securities

in Arlington, Va., took a less extreme view -- at least on the week's political developments.

"I do think the Bush administration is somewhat on the defensive and will lose the ability to set the agenda" because of Jeffords' switch," Gabriel said. But the outcome won't be either "blessed gridlock" or death to Bush stocks.

For example, a tax-cut bill is "9 centimeters dilated" and the Democrats are now more eager to see its final passage through conference because they cannot take over control of the

Senate

until the legislation is finalized, he noted with amusement. The "Jeffords thing" also makes a "substantial rebate check more likely," putting money in consumers' pockets by late summer, which should be a boon for retail stocks, the analyst added.

At publishing time, Senate and

House

members still were in conference, trying to reach a final agreement on the tax-cut bill.

Looking ahead, Gabriel noted that if a $1.35 trillion tax cut were passed, there would still be a $2.7 trillion surplus not earmarked for Social Security or Medicare, based on Congressional Budget Office estimates.

"We may have gridlock, but it ain't going to stop

Congress

from whittling down the surplus," he forecast. "It's a different kind of gridlock

vs. the 1990s and not bond-market friendly. It could have some negative consequences for the market."

Even if legislation is never passed, Democratic control of the Senate could result in "headline risk" for the drug industry, HMOs, specialty finance, and electricity and energy, he said.

On the other hand, Gabriel said it's far better that Jeffords switch now, instead of before passage of the budget resolution when "blessed gridlock could have been cursed gridlock" if partisan rancor blocked the tax bill. Additionally, he expects any Democratic spending initiatives will be met by "quid pro quo" spending on defense; thus, he believes the market's initial reaction in defense stocks is "wrong."

Be it political developments, rising tech valuations or the future of monetary policy, Wall Street had plenty to worry about this week, as reflected by the stalling of the market's broad-based advance. With earnings warnings expected to pick up in the coming weeks, skeptics say the recent advance soon will prove to be a mere "spring fling."

But optimists believe a little worry is a "good" thing for stocks, and note summer is a time when romance often blossoms.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.