Context, Causation, Correlation

In this weekends Barron’s, Michael Santoli asks this question:

“Is it possible that an Obama victory wouldn’t, in itself, be unfriendly to market returns? Re-election of an incumbent is rarely jarring for financial markets and usually requires an improving domestic economy. And second presidential terms are about legacies, rather than heavy-handed policy-making. It’s fair to say that this idea is outside the mainstream of Wall Street thinking.”

This is one of those comments that lead to misinterpretation, logic errors and deductive flaws. Santoli understands the issue, but its so easily misinterpreted by investors. Let’s briefly deconstruct this paragraph, and explain why it may be misinterpreted:

1) Misplaced Credit: As we have stated repeatedly over the past few election cycles, Presidential market blame & credit is greatly exaggerated. The bottom line is that the US chief executive gets more credit for good markets, economies and business cycles, and more blame for when they are poor than is remotely reasonable or fair. This is true regardless of party, economy, cycle, etc.

2) The Obama Bull Market: If you don’t buy into my arguments about the gross credit/blame exaggeration, than why are you concerned about any incumbent victory? The S&P closed at 850 the day before Obama was sworn in; yesterday’s close was 1,280.70 — a 51% gain over three years. If you buy into the foolishness that President’s drive markets, than given his giant market gains,  Obama is your guy.

3) Understanding Causation and Correlation: The error that the politicos often make is anthropomorphizing markets. You can see this in their language: Markets “prefer” one candidate over another, as indicated by short term rallies and sell offs. They show markets rising and falling with a candidates polling as proof of this. In the process, they make the classic correlation error, failing to recognize the same forces are driving both sets of numbers.

The effect of economy being either good or improving significantly is that it impacts profits. When earnings are expanding, they support higher stock valuations. Hence, the same underlying factor typically leads to both rising stock prices and improving incumbent polling.

Market participants should learn to understand Causation, and recognize when a false correlation pops up. They also need to put the day-to-day noise into the larger context of quarters and years. Doing so will help them become better investors.

>

Previously:
Presidential Blame & Credit (November 22nd, 2011)

The Market Magic of Democrats vs GOP Presidents (December 3rd, 2011)

Source:
Thought Experiments
Michael Santoli
Barron’s January 7, 2012
http://online.barrons.com/article/SB50001424052748704330804577138672645756272.html