With the race for the White House so far dead heat, anyone looking to invest based on the likely outcome is flummoxed. Conventional wisdom holds that reelection for President Bush will benefit certain sectors, while a victory by Senator John Kerry will boost others (see BW Online, 8/20/04, "Bush or Kerry: The Impact on Stocks").
To Barry Ritholtz, chief market strategist at New York investment firm Maxim Group, that's the wrong way to look at it. It's not about the markets reacting to election worries. "It's the other way around," he says (see BW Online, 8/30/04, "Navigating an Election-Year Market").
BusinessWeek Online's Karyn McCormack corresponded with Ritholtz by e-mail about his take on the market and the election. Here are edited excerpts of their exchange:
Q: How do you think the upcoming Presidential election is affecting the stock market?
A: The markets are impacting the [race]. The capital markets act as a future discounting mechanism, anticipating economic conditions 6 months to 12 months into the future. Politics matters far less to asset managers than whether the economy is expanding or contracting. Markets may not always get it precisely right, but they come close enough that it's wise to pay attention to what they're saying.
Q: And what are the markets saying?
A: As the economy slowed down -- and in the beginning of the year, the market correctly anticipated that it would -- businesses became less likely to hire, to give raises, bonuses, etc. When people feel less secure about their own financial positions, they become less optimistic about the future. That makes them far less likely to buy equities.
That's why sell-offs in election years typically bode poorly for incumbents. The disconnect comes when voters assign credit or blame to the President for the economy's success or failure. Typically, Presidents have only a marginal impact on the economy, although it's arguable that this President may have had more influence than most. It's usually the Fed chairman who's the most influential economic player in Washington -- at least most of the time.
Q: Explain what you mean by "the market is a future discounting mechanism."
A: Markets show you how much investors are collectively willing to pay for something -- in this case, a $1 of future earnings. With trillions of dollars at stake, Wall Street attracts the best and the brightest minds to crunch the numbers, do the legwork, check the channels -- and find any advantage they can in forecasting the economy. That's why the smart money -- typically, big funds and trading pros -- are so often right. They have a lot of intellectual firepower, and they've done all the heavy lifting.
Markets don't actually predict anything. But they reveal what all that homework by all those really bright people found out, because those people vote with their dollars. When the majority of all investing dollars -- collectively, "the market" -- anticipates robust economic growth, they become willing to pay more for future cash flow and earnings and the markets go higher.
Conversely, when investors expect a slowing economy, which means weaker revenue and lower earnings, they become less willing to "pay up" for earnings. That's what we have seen since January of this year -- the markets became less willing to pay a premium for future earnings.
Q: Who do you think will win the election?
A: I'm a numbers geek at heart, so I watch four quantitative factors that have had a strong historical correlation with incumbent electoral victory, regardless of party. The first is job creation, second is Presidential approval rating, third is percentage saying the country is going in the right or wrong direction, and the fourth is the Dow Jones industrial average performance in the first half of the election year.
The polls are saying this is a very close race, but all four of the above data points suggest the incumbent is in deep trouble. Over a four-year term, when job creation is less than 5%, studies have shown it's a huge negative for the occupant in the White House. As of last month, we were at a negative 0.8%.
We see recent surveys showing the incumbent polling less than a 50% job-approval rating, and for the "right/wrong direction" question, only 36% are answering "right direction." These are big negatives. The Dow started the year at 10,450. It has come up off the lows but is still down for the year. It's a minor negative.
Q: So you think Kerry will win?
A: Here's where things get tricky: Once all the quantitative data is in -- and assuming there's no "October Surprise" -- I look for an analogy with another, historically similar period. This includes economic data -- interest rates, taxes, unemployment, inflation -- as well as geopolitics.
What makes the 2004 election such a challenge to forecast is that we have never seen a Presidential term with a burst market bubble, a recession, a major terrorist attack on U.S. soil, a big tax cut, and not one, but two, wars. So without an analogous comparable, making a prediction with a high degree of confidence becomes quite problematic -- it's just a crapshoot.
If you won't let me weasel out of giving an answer, then I'll fall back on quant work. All four data points suggest the incumbent gets defeated in November.
Q: Doesn't Wall Street typically prefer Republican Presidents?
A: Ideally, the Street prefers a divided government: The best stock markets of the past three decades have been under Presidents Reagan and Clinton. Reagan was a Republican with a Democratic Congress, while Clinton was a Democrat with a Republican Congress.
Gridlock works because it forces both sides to the middle. Pragmatic moderation is an effective economic policy. Hard-core ideological approaches tend to be disastrous.