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Confusing Cause & Effect: Elections and Markets

Its an election year, and that means sophistry and ignorance in equal measures will be flooding the airwaves and intertubes.

We have taken it as our charge here to fight against the logically challenged and the factually incorrect. We addressed this exact issue four years ago, but given the propensity us Humans have for self-delusion, we must crank up the wayback machine, and review some basic economic and logical truths.

The latest meme making the rounds -- I've seen it in the WSJ, on Kudlow's show and read it online -- is a move to blame the recent market turmoil on the rise of Obama at InTrade, or to correlate the sell-off with the declining polls for the incumbent party.

The WSJ fell prey to this same reasoning:

"Worry about possible policy changes can weigh on markets ahead of a presidential vote. If an incumbent seems likely to win, markets often recover by the fall. This year, with many of the candidates on both sides promising change, the risk is that the market jitters could linger."

Markets do not recover because the incumbent seems likely to win; rather, the underlying conditions that work to the advantage of markets -- robust growth, brisk consumer spending, job creation, income gains, tame inflation, etc. -- also work to aid the incumbent.   

Consider the following chart, via Ned Davis Research:
click for bigger graph

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We all fall under the spell of faulty logic sometimes, confusing what is cause and what is effect. As another example of this, consider the following:

"Obama is currently the presidential frontrunner. Note that, on Intrade, the market odds of an economic recession in 2008 are rising in tandem with the odds that Obama will be elected President. Correlation does not prove causation but this correlation is worrisome."

All too often, we see the cause and effect relationship analyzed exactly backwards, as in the above example. These causative errors are an all-too-common analytical blunder when reviewing market or economic data. Unfortunately, in seeking certainty in an uncertain world, confusing cause and consequence is an all-too-regular occurrence. The above quote is a perfect example of that foible.

To review: Markets are not skittish because the incumbent party is in trouble - that’s getting it ass-backwards. When the ruling party is in election trouble, its because the future discounting mechanism of markets is incorporating a slowing economy into its pricing. Markets may be imperfect and subject to the excesses of crowd behavior, but they eventually get the big picture correct. The current market malaise reflects a recognition what is occurring in the macro-environment.

In the present case, its a weakening economy and the prospect of decreasing earnings that is most impacting equity prices. Slowing industrial production, a weak dollar, faltering consumer spending, high inflation, and $100 oil, weakening job creation and real income losses are factors that impact equity prices -- and the electorate -- invariably hurting the incumbent party's election fortunes.

People who are content with the status quo and secure in their financial futures vote for more of the same; when they are not, they vote for change.

Thus, the Cause is the weakening economy and its discontents thereto. The Effect is the rise of candidates claiming to be change agents, and fall of those representing the status quo.

Want to see a good example of how politicians recognizing this economic discontent (aka "Cause") ? Look at how often members of the incumbent party use the word "change."

I'm a political independent -- I supported McCain in 2000, and I would support a technocrat like Mayor Bloomberg today -- but these arguments all smack of partisan cheerleading to me. I even recall back in 2004 that the same faulty argument was made in a WSJ editorial: "Kerry Up, Markets Down." The Obama claim appears to me to be more of the same . . .

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One final thought: Its even more spurious to rely on Intrade as a source of what is roiling markets. The presidential and political predictions markets are notoriously unreliable, especially far in advance of actual elections. But its not just far in advance: Recall how wrong the prediction markets were with Howard Dean and Iowa, and with the GOP retention of the Senate in 2006.

As of yesterday, the Intrade bet for Obama to win New Hampshire was over 95% -- Whoops!:   

Final settlement: Obama to win NH expired at 0.0.   

To quote Dan Gross, these are "less futures markets than immediate-past markets."

In an upcoming post, we will review the strengths and weaknesses of these thinly traded prediction markets . . .

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Source:
Campaign Talk Gives Market Further Jitters
Promises of 'Change,' Economic News Blend To Unsettle Investors
E.S. BROWNING
WSJ, January 7, 2008; Page C1
http://online.wsj.com/article/SB119966775786271209.html

Logical Reasoning Errors: The Dow Election Year Cycle 
The Big Picture, Thursday, August 12, 2004 | 07:14 AM     http://bigpicture.typepad.com/comments/2004/08/dow_election_ye.html

Obama, the Election and the Economy
Jonathan
Chicago Boyz, January 6th, 2008
http://chicagoboyz.net/archives/5470.html

Iowa and Prediction Markets
The Big Picture, January 24, 2004 | 11:15 AM    http://bigpicture.typepad.com/comments/2004/01/iowa_and_predec.html

WHY WERE THE POLITICAL FUTURES MARKETS SO WRONG ABOUT OBAMA AND CLINTON?
Daniel Gross
Tuesday, Jan. 8, 2008, at 10:12 PM ET   
http://www.slate.com/id/2181745/

Wednesday, January 09, 2008 | 06:25 AM | Permalink | Comments (33) | TrackBack (1)
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Comments

I'm just happy that it's not "Republican Ken"(Mitt) Vs. "Democrat Barbie"(Hillary.

That would just be a Snoozer into november.

hey the futures are up, the market must like Hillary.(that horseshit is some of the most backwards thinking ever.)

Posted by: Eric Davis | Jan 9, 2008 7:00:25 AM