NEW YORK (TheStreet) -- The biggest event for investors over the next six months is likely to be the November elections in the U.S. The outcome of the elections will define the political context and leadership for policies that address the looming fiscal imbalances coming to a head in early 2013.We have explored this budget bombshell in prior commentaries and what it could mean for the markets and economy. This week we will take a look at what the market is pricing in regarding the election outcome. As we explore the issue of what the market is pricing in when it comes to the outcomes of the November elections, it is important to be aware of the shortcomings of overly simplistic election analysis. An illustration of this can be seen in Chart 1, where we plot the odds of President Obama's re-election (measured by contracts traded on Intrade.com) and the movements in the stock market, measured by the S&P 500 Index. Is the stock market going up because of the rise in Obama's re-election odds, or are Obama's re-election odds going up because the stock market is rising -- or, more likely, are both tied to something else?
While there are many "man on the street" polls, what matters most to investors is what is priced in on Wall Street rather than what people are saying on Main Street. A stock market based "election poll" is useful in that it highlights what the market is pricing in about the outcome of the election that is more refined than merely looking at the overall market. Based upon these legislation-sensitive industries, we have created two indices to help us track the markets' implied forecast of the election outcome reflected in the performance of these industries. Each index is composed of an equal weighting among seven industries that combined total about 100 S&P 500 stocks.
To track what the market has priced in for the Democrats' odds of retaining the White House and Senate we have taken the Democrats index and divided it by the Republicans index. An upward sloping line suggests the market may be pricing in a rising likelihood of the Democrats retaining the White House and their majority in the Senate, while a downward sloping line suggests improving prospects for the Republicans. While other factors may influence the relative performance of these indexes, as time goes on the election consequences may become paramount as investors increasingly vote with their money. As you can see in Chart 2, already this year Obama's re-election odds on Intrade.com are generally tracking the relative strength of our Democrat vs. Republican indices. If you elect to follow our "Wall Street' election poll index, we pledge to continue to keep you informed as to how these issues are likely to affect the markets. We will update this index frequently as the election becomes an increasingly important driver of the markets over the coming six months.