A Political Punch

Yesterday's market commentary ("Timing Tortillas") reminded us of one compelling fundamental likely to drive great stock returns this year. Gutless politicians. Democrats captured a slim majority on promises to legislate until they bleed. End the Iraq war! Cure global warming! End corruption! Close the income gap! Yet, implementation of their lofty goals has fallen a tad short.

Did our legislators even intend to legislate? We suspect no. Congress's first order of business was a raft of non-binding regulations, and then Madame Speaker decamped for sites exotic. (Perhaps she didn't really want to be Speaker—she was angling for Secretary of State.) Next up, the Senate Committee on Banking held hearings to skewer the perpetrators of the sub-prime "crisis." Their ultimate decision was, thankfully, to do nothing. But hearings are fun!

So fun, we had yet more hearings on the invidious, shadowy forces causing higher gas prices. Maybe our dear legislators should read reports penned by their own committees. The Government Accountability Office reported just last week that higher gas prices are caused by—wait for it—higher demand and constricted supply. Oh, and government regulation. Not to be outdone, this week (former) Senator Edwards is demanding still more hearings! On the high price of gas! (Perhaps his hair salon doesn't have a subscription to a national newspaper.)

We're not in the least bothered by a do-nothing Congress. In fact, we expect and welcome it. Why? This is the third year of President Bush's second term—and historically, third years are great for stocks—even for reelected presidents. Whereas presidential term front-halves have the lion's share of negative annual stock returns, back-halves are wondrously positive. And third years are best! We haven't seen a negative third year since barely-negative 1939. And third-year stock returns average about 20%—blowing away the average returns of the first two years, and even besting the fourth-year average of 13%.

But averages are just averages, and we should ignore them—right? Not always. Something powerful is driving this phenomenon. Like Bush-43 in 2006, the president's party almost always loses relative power in the mid-terms. (G.W. gained seats in 2002—an absolute rarity we're sure he didn't expect.) Therefore, presidents know they must ram through their pet agendas in the first two years, because not much will pass a less-friendly Congress in the back half.

Compounding presidential bias to legislate in the first half are 535 elected officials with one eye perpetually on the next election. History shows most of them aren't the least bit interested in legislating during the waning half either. If (when) legislation goes awry, people get blamed. But failure to legislate—that's election fodder! And it's never their fault—it was the uncooperative losers across the aisle.

And this year is living proof! But so what? How does that translate into a more profitable portfolio? Legislation is usually nothing but redistribution of money or property rights—there's a winner and loser every time. We know humans feel the pain of loss over twice as acutely as the pleasure of gain. And what does a normal person do when a fist flies toward their face, but wince? Even if the fist isn't flying towards us specifically, we still wince in fear—the bully might get us next. That wincing is legislative risk aversion.

In the back half, particularly the third year, not much legislation is likely to pass—and historically, this has been true—so we fear the legislative punch in the teeth less. Less legislative risk aversion leads to more uniformly positive and better stock returns. Simple as that. So let Congress bluster. They're doing us a bigger favor than they know.