There are several steps to the analysis.
Predicting the Outcome
The general expectations and polls, reflected by odds on the University of Iowa election market and Tradesports.com, suggest that the Democrats may gain control of the House, but the Republicans will retain control of the Senate. The latter is a bit complicated, since a 50-50 split leaves GOP control. Vice President Cheney can cast a deciding vote on any tie. There is also the question of how Joe Lieberman, running as an Independent, will choose his party affiliation in the Senate organization.
The markets currently predict that the Dem's will win the House and the GOP will retain Senate control. Larry J. Sabato's excellent site today predicted (subject to last-minute swings, etc.) that the Dems would win Senate control as well.
The three key Senate races are too close to call, but there is a very real chance that the Dem's will take control of both houses.
What would be the meaning of a Democratic sweep? In the election rhetoric, there are many scary projections about who would have various leadership posts and committee chairs. In reality, for the markets and the economy it makes little difference.
The history of the Bush administration has been marked by highly partisan positions where a narrow vote was enough to make law: House, Senate, and President all in agreement. There has been little in the way of bi-partisan agreement. This is about to change. Existing laws cannot be undone even if the Dems win both houses. We would see an outbreak of Presidential vetoes, with no ability to override them. Despite the rhetoric, the Dems are both unlikely (see the latest stories) and unable to end market-friendly tax decisions from the first Bush administration. These decisions will be made years from now with a new President and Congress. That is the reality.
Democrats would be able to have more influence over appointments, and a lot of control over new legislation. These are not the most significant factors for the market. The real battleground will be in 2008, when there is a Presidential election. At that point, market analysts must consider the implications for globalization, free trade, tax policy, health insurance requirements, and other similar issues.
Despite this substantive analysis, a market strategist must look to the perceptions of others. Astute observers like Scott Rothbert believe that a Democratic sweep would be a big negative for the market. Other analyses, like this one from Barry Ritholtz, show a different picture.
Briefly put, even if my analysis of the actual impact is correct, the market may find the prospect frightening. I can wish that they had all taken my courses, but that does no good! The consequence is that those who find stocks attractive at current prices must deal with a fear that might not have a sound, rational foundation.
What is "Baked In?"
The market seems ready for the Dems to win one house, but not both. Even if one agrees with my analysis of the impact of a Democratic sweep, there will probably be a knee-jerk reaction. Who knows how long it will take for market participants to see the reality of gridlock.
Like many market situations, this is one where you can be right on the facts and still wrong on the market effect. We will all be watching with interest on Tuesday night.