Investors Should Ignore Economics & Politics

Voters should pay attention to politics. Investors should ignore it.
By Barry Ritholtz
Washington Post, March 8 2013

On March 1, the $85 billion sequester went into effect. It will potentially shave half a percentage point from GDP. With estimates for this year’s economic growth at 1.5 to 2.0 percent, the sequester by itself is unlikely to cause an actual contraction, but it will reduce the level of U.S. growth.

How will this affect investors’ portfolios? Most folks seem surprised when I tell them the sequester will have “little or no” impact on markets. The correlation between how markets perform relative to economic events is actually quite weak. Let’s take a closer look:

Economic data: Most of the time, economic data is fairly benign. I don’t wish to imply it is meaningless, but it is not a driver of stock markets. Indeed, the correlation between economic noise and how equity markets perform has been wildly overemphasized. To quote Warren Buffett: “If you knew what was going to happen in the economy, you still wouldn’t necessarily know what was going to happen in the stock market.”

The economic cycle sees a constant stream of news. Various data are released on a recurring weekly, monthly and quarterly cycle. Sometimes they improve; sometimes they degrade. These are minor and noisy fluctuations, often reflecting flaws in how the data are collected or seasonally adjusted.

There are many reasons why economic data are so noisy, none of which matter to the primary driver of your investments, namely corporate profits and equity valuations.

Let’s look at Friday’s employment situation as an example: Most traders consider the nonfarm payroll release to be the single most important economic data of the month. But consider what it is that is actually being modeled. There are about 150 million Americans working full time. Each month, between 3 million and 4 million leave those jobs; another 3 million to 4 million start new ones. What the monthly employment situation report measures, in very close to real time, is the change in that number. You take the total number of new hires, subtract the total number of job losses, and that leaves the marginal net change in employment.

Given that the starting number is so big and the monthly net changes are so small, the overall change is almost statistically irrelevant — most of the time, less than 0.1 percent.

But wait, there’s more. That number gets revised as data are updated later in the year. It is revised a second time when a benchmarking is done sometime after that. Suffice it to say that the final revised, benchmarked employment number often looks nothing like the original release. (They don’t call them estimates for nothing.)

Thus, any single 0.1 percent data point needs to be recognized for what it is: one data point in a much longer series.

What I actually watch the data for are signs that the primary trend may be undergoing a significant change, such as an expansion reversing, suggesting a possible contraction. Since World War II, there have been 12 economic recessions — one about every five and a half years on average. Minor recessions (i.e., 1990) tend to drive stock prices down 20 to 30 percent, albeit temporarily. These downturns create good buying opportunities, as they allow long-term investors to make equity purchases at attractive valuations.

Consider: Even though more than half of the 41 OECD nations are currently in a recession, the present cyclical bull market dating back to March 2009 is the sixth-best rally since 1929.

As the statistician George Box put it three decades ago, “All models are wrong, but some are useful.” Hence, we pay attention to them only when they are warning us of a major shift in the overall trend, and ignore the weekly or even monthly fluctuations.

Political issues: If I have convinced you that economic data matters less than you previously believed, imagine how little political issues matter.

Washington reads like a novel designed for media coverage: The narrative follows classic lines of dramatic literature, with lots of colorful characters, conflicts that build to a major crisis, followed by some form of resolution. We then turn the page, moving onto the next crisis. Each of the chapters in this saga is depressingly similar.

The media may give heavy play to the political angles, but the overall impact on your investments is de minimus. Consider some of the most tumultuous events of the past century: the attack on Pearl Harbor, which led to the United States entering World War II; and the Soviet Union’s launching of Sputnik into space, which kicked the Cold War arms race into high gear. Consider these presidential events: John F. Kennedy’s assassination, Richard Nixon’s resignation, Bill Clinton’s impeachment.

Oh, and the debt-ceiling debate of 2011 and the sequester of 2013.

In none of the above did the markets react unusually. At most, they wobbled a bit before resuming their prior trend. Even the horrific attacks of 9/11, which saw markets closed for almost a week, was followed by a selloff, then a rally, then a return to the prior trend, which was the ongoing deflation of the dot-com/tech bubble.

The lesson for investors is that while these events may transfix us emotionally, they have almost zero impact on corporate earnings. This is the primary factor in driving valuation, and that is what ultimately drives your investment results.

Bubbles: Speaking of which, I am much more concerned with the development of major asset bubbles than I am with any political developments in Washington. These are great fun on the way up, as they generate tremendous short-term gains. They are much less fun on the way down, unless you are fortuitous enough to have gotten out of the way in time. Asset managers who lacked a robust approach to risk management and capital preservation learned the penalties for ignoring absurd valuations.

When these bubbles pop — for example, tech in 2000, housing in 2005-06, banks in 2007 — the damage is often 50 percent-plus market crashes. The sector-specific damage is even worse: Think tech, homebuilders and banks, which suffered collapses of about 80 percent. In each of these cases, a recession followed the popped bubbles. The key word is “followed.”

This is why valuation is a much more important component for investing than people believe. It is also the reason why economic data matters far less than most people think.

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Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. On Twitter: @Ritholtz.