First, consider the classic “causation/correlation error” — one that pundits make all the time. This occurs when two factors happen at similar times, and an assumption is made that one is causing the other. Correlation errors confuse cause and effect. Typically, a more significant but overlooked factor is driving the outcome.
Here is a classic example: “The incumbent’s poll numbers are rising, and the S&P 500 likes it. It has been rallying in response.”
Not exactly. There is a third explanation, and understanding this requires thinking about what is common to both incumbent polls and stock markets. Instead of assuming that one is causing the other, we need to look for broader forces that are driving both elements.
Most of the time when an incumbent is doing well in the polls, it is because the economy is doing well enough (or improving fast enough) that it is generating solid corporate earnings, strong hiring and positive consumer spending. That not only drives stocks and markets higher, but also makes voters feel economically secure. This works to the advantage of the sitting president. Note that the opposite is also true: Markets do not do poorly because the challenger is polling well; rather, the conditions that help a presidential challenger obtain victory — weak job availability, unhappiness with the economic conditions, desire for change — are negatives for earnings and the markets.
Don’t expect to hear this straightforward reasoning from the punditry. During the silly season, politicos and cranks push all manner of sophistry and ignorance onto an unsuspecting public. We’ve seen it in the editorial pages, from guests on my pal Larry Kudlow’s show, and all over the intertubes. Too many folks blame every twitch of the market as a reaction to the politician they like or dislike the most.
The shorter-term swings are especially nonsense.
Let’s consider what is driving day-to-day stock prices: It’s not expectations about changing capital gains taxes or broad shifts in health-care spending — issues that arguably can be game-changers in elections.
Rather, large hedge funds and high-frequency traders are the biggest participants short-term. The machine-driven mathematical traders have no interest in politics; their stock purchases are held for milliseconds, and their buying is driven by quantitative formulas that have nothing to do with any candidate. Hedge-fund managers certainly are not making bets dependent on the outcome of elections 10 months hence. They are more concerned with monthly, weekly and even daily performance. The technical factors driving what they do are far removed from whatever is happening on the campaign trail.
These simple facts never seem to get in the way of the op-ed writers at various journals who seem to favor arguments along these lines: “Worries about possible policy changes are weighing on markets ahead of the year’s presidential elections. Candidate X’s rise in the polls is a risk that is giving the stock market jitters. Stock prices are wobbling, all leading to uncertainty. (And the markets hate uncertainty.)”
This analysis — to use the word loosely — is misleading and flawed. Investors should avoid misconstruing information from polling and extrapolating it toward markets. Here are some other arguments to watch out for:
Misplaced credit and blame: Presidential blame and credit for the markets is greatly exaggerated. The U.S. chief executives get far more credit than they deserve for good markets, economies and business cycles. They also get more blame when the economy is weak than is reasonable or fair. This is true regardless of which party wins the White House, or where the economy is in its cycle.
The Obama bull market: Perhaps you don’t buy my arguments. Then you must obviously be rooting for an incumbent victory. Why is it that? Consider how the markets did under George W. Bush, the most recent “pro-business president.” Then imagine how markets probably reacted to the anti-business socialist from Kenya.
I have some disappointing news those of you who believe in such utter silliness: The S&P started at 850 the day Obama was sworn in; last week it hit 1292 — a better than 50 percent gain over three years. (If that’s anti-market, I’ll have some more, please.) In 2001, when Bush was sworn in, the S&P stood at 1343. He left at 850 — a decline of about 37 percent.
If you buy into the foolishness that presidents drive markets, than given his giant stock gains, Obama is your guy.
Anthropomorphizing markets: Politicos make another analytical error in the language they use: Markets “prefer” one candidate over another; polls are validated by short-term rallies; a disliked candidate’s latest stump speech is what drove the last sell-off. It is a trick used to frame issues, and it is disingenuous at best. Indeed, with these silly claims, pundits manage to combine all of the analytical errors discussed above.
Perhaps it helps to think of markets as future discounting mechanisms. Whenever an economy is slowing, markets price in the possibility of worse profits and sales. (My experience is this occurs three to six months in advance.) Markets are imperfect, subject to excesses of crowd behavior, but they get the big picture correct eventually. When the economy is improving, you will see that reflected in improving stock prices, often in advance of the stronger economic data.
Weak job creation and slow sales both affect equity prices, the electorate and the incumbent party’s election fortunes. When folks are content with the status quo and feel secure in their financial futures, they vote for more of the same; when they are not, they vote for change. Thus, the cause is the weakening economy and its discontents thereto. The effect is the rise of candidates claiming to be change agents — and the fall of those representing the status quo.
The underlying conditions that lead to strong equity markets — robust growth, job creation, brisk consumer spending, income gains, tame inflation, etc. — also work to aid the incumbent. It is not that markets like incumbents, it is that both markets and incumbents do better when the overall economy is doing well.
Putting the day-to-day noise into the larger context of quarters and years will help make you a better, smarter investor.
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. Twitter: @Ritholtz.