With the general election less than eight months away, some analysts have started warning investors about the dangers of a Democratic victory. It's a thesis the market generally buys.

If presumptive Democratic nominee John Kerry were to be victorious in November, they say, taxes will go up, stocks will fall and bonds will become the investment of choice. But would Kerry really be so terrible for Wall Street?

Investors seem to think so. Stocks fell sharply on Monday partly because of concerns about global violence but also because this violence reflects badly on President Bush and hurts his chances for re-election. Criticism of Bush from antiterrorism expert Richard Clarke also was cited by some pundits as a contributing factor to the market's slide.

The greatest concern among analysts and investors seems to be that Kerry would raise taxes on dividends and capital gains. The top rate for both was lowered to 15% last year, and some analysts claim that this buoyed stocks in 2003. The tax cut is set to expire at midnight on Dec. 31, 2008.

Analysts argue that Bush would push to make these tax cuts permanent and could even advocate lowering these rates to zero, something that is deemed bullish for stocks.

Still, it isn't clear that Kerry would increase taxes on dividends and capital gains. Because he hasn't mentioned the issue so far, many Washington observers assume he won't touch these rates, although he almost certainly would raise the top income tax bracket.

There's also no guarantee that Bush would be successful in lowering dividend and capital gains rates to zero or extending the tax breaks. After all, he had little success doing this in 2003. Although the composition of the Senate could change in November, giving more control to Republicans, it's not certain that there'd be enough support to cut taxes further or make existing tax cuts permanent.

Right now, the Senate comprises 51 Republicans, 48 Democrats and one independent. In November, 34 seats are up for re-election. All 435 of the House seats are up for election, as is the case every two years, and right now there are 228 Republicans, 205 Democrats, one independent and one vacancy.

Greg Valliere, managing director at the Charles Schwab Washington Research Group, said if Kerry were to win, one or both houses of Congress likely would remain in Republican hands, meaning that gridlock would reign in Washington. And gridlock has historically been positive for the financial markets.

"The House is about as close to a sure bet as you can find. Even if Kerry were to win, the Republicans might even gain a seat or two in the House," Valliere said. "The Senate in the past couple of weeks has become a slighter, tougher call, but I still think the Senate will probably remain Republican."

For the Democrats to have a majority and gain control of the House, they need to win 12 more seats, "which seems unlikely given that there are only a small number of competitive races," noted David Rosenberg, chief economist at Merrill Lynch. Still, more Republicans than Democrats are retiring in November.

In the Senate, Rosenberg said many experts see only about 10 close races "and it could well be that in this chamber the Republicans will actually add to their majority, though likely fall short of the 60 needed to overcome Democratic filibusters."

During periods when only one party held power in both the legislative and executive branches, Rosenberg said, the S&P 500 rose at an average annual rate of 3%. But when power was split between the two levels, the market was up at a 9.7% average annual rate.

He also noted that when one party was in control of both the White House and Congress, bonds typically sold off and the yield on the 10-year Treasury note rose at an average of 48 basis points. When power was split, however, bonds rose and yields fell an average of 25 basis points.

A divided government often bodes well for stock prices
White House House Senate S&P 500/CAGR*
2001-Present Republican Republican Republican -4.3%
1995-2000 Democrat Republican Republican 19.2
1993-94 Democrat Democrat Democrat 2.7
1987-92 Republican Democrat Democrat 10.3
1985-87 Republican Democrat Republican 13.9
1981-84 Republican Democrat Republican 5.4
1977-80 Democrat Democrat Democrat 6.0
1968-76 Republican Democrat Democrat 1.2
1961-67 Democrat Democrat Democrat 7.5
1955-60 Republican Democrat Democrat 8.3
Average One Party 3%
Gridlock 9.7%
*Compounded annual growth rate
Source: Merrill Lynch

"Gridlock is good because it means they do less harm," said Valliere. "If there's one thing that the financial markets hate, it's uncertainty, so if you've got gridlock, you remove that element of uncertainty on some curve ball that could come legislatively."

Valliere said concerns that Kerry would roll back the Bush tax cuts are unjustified. "There's no way in the world that Kerry could get something like that past the House Ways and Means committee, which is headed by Bill Thomas, a very conservative Republican," he said.

Of course, it's not just the issue of tax cuts that analysts worry about. They also believe that Republicans are generally friendlier to big business than the Democrats. On this subject, Valliere is inclined to agree.

"Kerry gets to appoint the head of the FDA and FTC and FCC, so all of these regulatory agencies would develop a much more adversarial relationship with business," he said. "Right now, it's pretty laissez faire and cozy. That, I think, will change."

He added that he would not be surprised to see a wave of mergers over the next few months because companies may start thinking that the regulatory climate will be less favorable under a different administration.

Still, Kerry's commitment to cutting the deficit could be a positive development for stocks. If the U.S. is perceived to be fiscally responsible, the dollar likely would strengthen and foreign inflows into U.S. assets could increase. Bush's proposal to halve the deficit in five years has been hailed by some as wildly optimistic.

Meanwhile, protectionist tendencies from the Bush administration are very unpopular among analysts. Although Kerry has recently started to sound like a protectionist, he has been one of the most ardent supporters of free trade over the past 20 years.

In the end, it's unclear whether Kerry or Bush would be better for the financial markets. But it's clear that gridlock has been good for stocks historically and that some of the concern over a Kerry victory has been misplaced. Whether analysts and investors recognize this in the future remains to be seen.

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