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Wall Street Finally Gets the Gridlock It Was Hoping For

Wall Street may want to be careful what it wishes for, particularly when it comes to gridlock.

The 2010 election cycle was filled with proclamations that Wall Street would be happy with a divided do-nothing government that would get out of the way of the free market and help clear the way for capitalism to work its magic.

But with a seemingly unbreakable impasselooming over what the White House has called a drop-dead date of Aug. 2 to get the $14.29 trillion national debt ceiling raised, the allure of gridlock seems to have dimmed.

"Gridlock is one of the things that keeps steps marginal and keeps them so they're insignificant and let's the free market dominate the outcomes," says James Paulsen, chief market strategist at Wells Capital Management in Minneapolis. "In this case, it's a good example of where gridlock can go too far, where a decision that has to be made can't get made."

Deadlock, it seems then, is best in small doses and administered only when a patient is not threatening to hemorrhage red ink.

"Gridlock is good as long you don't have major systemic risk in the market such as a debt default or the the mortgage crisis," says Mark Lamkin, CEO of Lamkin Wealth Management in Louisville, Ky. "When markets are humming along, even with mediocre growth and slow job creation, at that point gridlock is good. Neither party can muck it up and capitalism works. When you have a major problem like this debt ceiling, this type of partisan gridlock is absolutely horrendous."

The notion of "gridlock is good," at least in its most recent form, came largely from nostalgia for the Clinton years, when the 42nd president and a recalcitrant Republican Congress managed to create what economists call the Great Moderation—steady growth, low inflation and an overall friendly investor environment.

But the notion of divided government being good for the markets is mostly myth.

Over the years, the market actually has done best either with a Republican president whose party also controls Congress, or a Democratic president and a unified Congress (with both houses controlled either by Democrats or Republicans). The Standard & Poor's 500 has gained 15.1 percent in years bearing either of those conditions since the end of World War II, according to S&P data.

Conversely, divided government where the president and Congress are of opposite parties the market does poorest, gaining 3.8 percent under Democratic presidents and 3.5 percent under Republicans.

"A split Congress does not lead, they impede," says Sam Stovall, S&P's chief market strategist. "Now that the overall debt level is so massive, it has spawned a large number of extremists on both sides, making it increasingly challenging for centrists to arrive at a compromise."

The ratings part of S&P's business stands at the center of the debt controversy, warning that the warring Washington parties need to reach an agreement more focused on addressing the economics of future debt levels than the politics of the current ceiling. The ratings agency has said it will cut the US debt ratingif a long-term solution is not reached.

"Washington continually gives Broadway a lesson in theatrics. This is no different," Stovall says. "Yet I still believe in 11th-hour miracles. Congress will put something together that at least raises the debt ceiling so we do not get into any kind of selective defaults.

"But it might leave open the question of a potential downgrade if it's not meaningful enough to keep our debt-to-GDP ratio below 100 percent over the coming couple of years."

That hope for a decent deal to get made is what has some strategists still touting the benefits of gridlock.

Should the two sides come together to work something out that meaningfully addresses the toxic government balance sheet while allowing for the smooth continuation of operations, it could lend more credence to the benefits of divided government.

After all, there is some extent of gridlock even within the two parties. Some Democratic centrists are looking to make compromises on taxes, while Republican counterparts are edging toward spending concessions.

"We've got a fragile economy and it's an economy that probably at this point could not withstand deeper austerity measures. Even within the Republican party itself, the gridlock is healthier," says Quincy Krosby, market strategist at Prudential Financial in Newark, N.J. "On the other side, try to imagine if the Democrats were completely in charge. You'd probably see tax hikes across the board, which definitely would not be good for an economy that's growing below 2 percent."

At the end of the day, all the bickering could produce something good.

"They way they're dukeing it out now, one could argue that the package that comes out ultimately is something that will be more balanced than what either party in control would give us," Krosby says.

If that happens, the clamor for divided government could grow only louder with presidential and congressional elections ahead in 2012.

"It's kind of like a mutually assured destruction policy. In the end, the result is going to be the same," says Doug Roberts, chief investment strategist for Channel Capital Research in New York. "Once they go through this equivalent of a reality TV series on Capital Hill, the result is going to be some type of resolution. Gridlock thus far is not really doing anything that's causing a major problem. It's more a perception issue than anything else."