Cheap gas to the rescue

LONDON (Fortune) -- The precipitous drop in gas prices - 25 percent since August - hasn't just been good news for Republicans eager to hold onto Congress. It's also come at the best possible time for the economy - and the stock market, pumping billions of dollars into the hands of consumers just as U.S. economic growth has slowed.

In the third quarter, economic growth was an anemic 1.6 percent, the weakest pace in more than three years, and high energy costs were among the main culprits for the summer slowdown. But Lehman Bros. senior economist Drew Matus predicts growth will rebound in the final three months of 2006 to 3.2 percent. "The fall in gas prices is almost perfectly timed, and it will also provide an offset to the housing market, which is weakening," says Matus.

Cheaper gas should also offset the biggest economic threat the country faces right now - falling housing prices and growing inventories of unsold homes. Economists say the drop in new home construction reduced GDP growth by a full point in the second half of 2006, and will lead to an additional half-percentage point in lost growth over 2007.

So the additional cash consumers will now save will be especially critical as the holiday shopping season begins. "If you think about it," asks Matus, "what has a greater impact: a fall in home prices, which only hurts if you're planning to sell or a weekly reminder that you've got more money in your pocket?"

Indeed, Merrill Lynch economist David Rosenberg estimates lower energy costs are equivalent to a $100 billion tax cut. "The drop in energy prices, the pause in the Fed tightening cycle and continued corporate M&A all bode well for the stock market," adds Charles Reinhard, director of portfolio strategy at Neuberger Berman.

So what's the best way for investors to play this angle? Naturally, key consumer plays like Wal-Mart (Charts), Federated Department Stores (Charts) and Home Depot (Charts) have been robust performers over the last month, rising about 10 percent, and if energy prices remain low, they should be poised to benefit in the final months of the year.

What's more, the lower energy prices reduce inflationary pressures, which in turn might enable the Fed to hold off on any rate hikes, a bullish sign for financials like Capital One (Charts). The Virginia-based bank has been able to profit by expanding its credit card business and successfully managing risk, so a health consumer sector should continue to deliver big profits.

On the other hand, if oil prices rise, expect consumer stocks to be among the first hit. In fact, that pattern of trading has already kicked in - when oil rose on Friday, Wal-Mart and Federated both were down more than 2 percent on the day.

The best way to play this is diversified portfolio which includes shares of both consumer stocks and a few shares of Big Oil standards like Exxon (Charts), so you're covered in the event of a sudden cold snap that drives oil higher.

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Why gas prices dropped (Hint: It's not the Republicans)