It just doesn't matter that much to markets.

Photographer: Robert Nickelsberg/Getty Images

Confusing Cause and Effect: Election Edition

Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”
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2016 Race, Does the Market Care?

As you surely know, this is an election year, and that means a combination of sophistry and ignorance is flooding the news media. The latest point of contention among the chattering classes concerns the financial markets, which so far this year have been anything but uplifting. The entire discussion represents a classic logical misunderstanding, although I suspect some disreputable partisans know this but traffic in it anyway.

This is yet another of my many pet peeves (see this, this and this), but one that I haven’t addressed recently.

I repeatedly heard (and read) the same silliness over the weekend: The market is tanking because of the rise of the wildly unpredictable Donald Trump on the right and the socialist Bernie Sanders on the left. This spawned further questions about what does nominating or electing one or the other mean for the parties, the elections, the stock market, even the future of the U.S.

I can’t answer most of those questions, but I can say that as far as the market is concerned, the whole political horse race and even the election itself is more or less meaningless. The election is simply another factor -- and a relatively minor one at that -- to be digested and discounted in prices. Let’s look at why.

Begin with the simple acknowledgement that stock and bond markets don’t prefer anyone or anything. We tend to anthropomorphize markets too much, and doing so can be detrimental to an investment portfolio. Markets are simply venues where capital is placed at risk. Collectively, they have no special insight. I am in complete agreement with Oaktree’s Howard Marks, who observes:

So, what does the market know? First it’s important to understand for this purpose that there really isn’t such a thing as “the market.” There’s just a bunch of people who participate in a market. The market isn’t more than the sum of the participants, and it doesn’t “know” any more than their collective knowledge.

This is a very important point. If you believe the market has some special insight that exceeds the collective insight of its participants, then you and I have a fundamental disagreement. The thinking of the crowd isn’t synergistic. In my view, the investment IQ of the market isn’t any higher than the average IQ of the participants. And everyone who transacts gets a volume-weighted vote in setting an asset’s price at a given point in time.

That sums it up well. Markets can help with price discovery of an actively traded asset class, but they don’t offer much insight into the rest of the world.

I mentioned Paul Samuelson’s famous quip last week that the stock market has predicted nine out of the last five recessions, and its acumen is no better for politics.

When you combine the classic correlation versus causation error with a partisan narrative, plus all of the emotional baggage that goes with that, you end up with a story line that is all but guaranteed to be wrong.

In the typical election, we hear that the market is strong (weak), that is a positive (negative) for the incumbent and that we can see the results in the challenger’s rising (falling) poll numbers.

This sort of analysis is muddled.

The proper way to put this into context isn’t to think of this as a causal relationship between two variables; rather consider these two variables -- markets and polling data -- within a much more complex dynamic system.

For a moment, imagine that the incumbent of either party is enjoying a robust recovery. People are working, unemployment is low, wages have risen, consumer spending is brisk, corporate profits are strong and rising. All of these should help both the stock market, and the incumbent’s party.

Conversely, during a recession, we see the opposite happen: Unemployment rises, consumer spending falters and profits are declining. These factors hurt the market, and that hurts the incumbent’s poll numbers.

It isn’t that one factor causes the other; it’s that they both are affected by the underlying strength or weakness of the economy. (I’ll save the discussion about how we give presidents too much credit and blame for another day).

Getting this mixed up is a very common error. It is why I have said repeatedly that politics and investing don’t mix

So go ahead, listen to the pundits, if you must. But understand all that commentary for what it is: biased and emotional narratives. And never ever act on it in terms of your investment portfolio. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Barry L Ritholtz at britholtz3@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net