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.