Barry Ritholtz
Confusing Politics With Economics
 By Barry Ritholtz
RealMoney.com Contributor

7/28/2004 2:30 PM EDT
URL: http://www.thestreet.com/p/rmoney/barryritholtz/10174814.html
 Market Analysis
  • When it comes to politics and the markets, don't rush to make cause-and-effect connections.
  • Incumbents find themselves in re-election trouble when the market's future discounting mechanism incorporates a slowing economy into its pricing.

    • A core tenet of my investment philosophy is that you can't think clearly about the future unless you have a firm grasp on the present -- where the market is now and how it got here. This is true regardless of whether you're a trend follower, a swing trader or a fundamental analyst.

    At any given moment, however, the market is hardly a reflection of the day's headlines. All too often, I see and read pundits discussing the indices as if they react primarily -- even solely -- to the wires and latest press releases. If only it were that simple.

    The Latest Culprit

    Take the recent selloff from June 30 to July 26, for example. As the indices have been flailing about, groping for a bottom, the chattering classes (including me) have searched for an explanation. In their hunt for what's been bothering the market, they have discovered a new culprit: politics!

    Consider this comment in Monday's Wall Street Journal. A bulge bracket firm's political analyst observed: "I would consider that uncertainty around the outcome of the presidential election is one of the major influences on the skittishness in the U.S. market."

    As Jim Cramer would say, Wrong! This observer gets the cause-and-effect equation exactly backward. Unfortunately, this misunderstanding of the relationship between politics and economics is all too typical. Given the search for certainty in an uncertain world, confusing foundation and consequence -- cause and effect -- is a regular occurrence. Politics perfectly epitomizes that foible.

    Causative Errors

    What are "causative errors"? This all-too-common analytical blunder comes in several forms. It often happens in attempts to oversimplify the market's natural complexity. The interrelationships of many different macro events don't make for good sound bites, yet we hear short buzzwords describing what's moving the market on any given day.

    When indices are vulnerable -- during mutual fund outflows, fading M2 supply or excessive bullishness -- I notice everything else but those factors getting blamed for selloffs. Instead, we're asked to pick our poison: profit-taking, earnings news, Alan Greenspan, economic releases, geopolitics, terrorism, etc.

    I have yet to find someone who can explain to me why some terrorist attacks roil the market, while others -- with the same appalling body count -- get shaken off. The horror of the situation is no less; the tragic waste of life no different. Yet the markets somehow have totally different responses to the same stimuli. So perhaps these headline events are not really causing the market to shudder and shake?

    The latest causative error, blaming politics for the market's malaise, is akin to blaming the rooster for the sunrise. Equity markets haven't been skittish because the incumbent is in trouble. Rather, incumbents find themselves in re-election trouble when the market's future discounting mechanism incorporates a slowing economy into its pricing.

    The market may not get it precisely right all the time, but it gets it right often enough to warrant paying close attention to what it's saying and why. If the economy slows, this gets reflected in the markets as lowered equity prices, often before the economic releases confirm it. Investors become less willing to pay more for slower growth, and that means weaker job growth. Invariably, this negatively impacts an incumbent's re-election chances.

    A Look at History

    Ned Davis Research did a recent study on post-World War II presidential campaigns and determined that while "job growth does not guarantee a victory, sluggish job growth historically has hurt the incumbent party." According to the study's data, the party in power lost the presidency whenever the change in nonfarm payrolls during the president's term was below 5%. This isn't a Republican or Democratic issue, but rather an incumbent vs. a challenger issue.

    During the 1957-1960 period under Eisenhower, nonfarm payrolls grew at 2.4%, and the incumbent party lost. From 1989-1992, job growth was 1.8% and, again, the incumbent lost. In the present cycle, from 2001 to June 2004, job growth has been a negative 0.8%.

    In light of these data, ask yourself: Are politics roiling the market, or are the economy and the market ailing the politicians?

    Of course, elections sometimes get decided on factors other than job growth. Despite fairly robust job growth during their terms, Gerald Ford and Jimmy Carter, for example, lost their re-election bids. Ford was contending with his pardon of Richard Nixon, and Carter had to deal with the hostage crisis in Iran, among other factors.

    While it may not always be "the economy, stupid," incumbents who ignore economic data do so at their own peril.
    Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to barry.ritholtz@thestreet.com.