Is Team Obama's Slump Powering the Market's Rally?

|
Includes: QQQ, SPY
by: Perry D.

The speed, scope and timing of the current stock market rally has been a mystery to many this year. The economy's dismal condition and prospects hardly seem to justify the market's rapid ascent. A similar mystery lingers about last year's stock market's plunge. The credit crisis alone never really seemed to fully explain its severity or timing.

Jim Cramer might have found part of the answer behind the big bungee jump, and it seems to explain a lot. It might even be worth going beyond the point he made: The stock market's ups and downs over the entire past 18 months may have had a lot to do with President Obama's downs and ups.

First, some context. Markets are forward-looking. They rise and fall based on expectations of what might happen -- fall when the future looks bleaker and rise when the future looks brighter. Profits or profit prospects just don't explain the current rally. Trailing and foward P/E ratios have widened dramatically.

Generally, the greater a country's economic freedom -- the more secure its property rights are, the lower the government's take, the freer its trade, the more flexible its labor laws, the fewer its restrictions on business, the lesser its corruption and more positive its investment climate overall -- the greater its prosperity and growth.

His moderate rhetoric aside, the recurring theme behind President Obama's economic proposals has been higher taxes (on estates, capital gains and income), greater regulation of the economy (of heavy manufacturing through "cap and trade", health care, finance and corporate pay) and greater borrowing (another $9 trillion projected over the next 10 years). If all of this happens, future growth will take an even bigger hit.

Could it be that the market's rally is an expression of relief that Obama might not get his way? Where's the evidence? Let's go to the videotape.

I looked at three time series:

  • A daily measure of Candidate Obama's pre-election odds, as measured by prices for "Democratic victory"/"Obama victory" futures (Iowa Election Futures market*)
  • President Obama's daily approval ratings (Gallup Poll)
  • The S&P 500 index

I ran a simple correlation analysis** of two relationships:

  • Pre-election: The S&P 500 versus "Obama-victory" futures prices
  • Post-election: The S&P 500 versus President Obama's approval rating

The strongest negative correlation you can get between two variables is -1, the weakest is 0.

The results are striking.

Before the election there was a very strong negative correlation of -0.87 between Candidate Obama's chances of becoming president (as measured by "Obama-victory" futures prices) and the S&P 500.

When Candidate Obama surged in the polls (and the election futures markets), the S&P tended to sink -- and the S&P tended to rally whenever the Obama campaign appeared to falter.

The relationship weakened somewhat after the election, but it remained firmly negative. A correlation of -0.55 is found between Obama's Gallup approval ratings and the S&P.

As statisticians say, "correlation doesn't necessarily mean causation," and movements of the two variables could reflect some other factors.

But the persistence of this statistical link and its revived strength over the past month are pretty compelling (though circumstantial) evidence that Obama's odds of policy success are playing a big role in the stock market's bungee jumps.

I hesitate to give politics too much weight in investment decisions (in anything, frankly), but Washington may have ballooned into the massive elephant (and donkey) in the room that neither investors nor anyone who writes about the markets can afford to ignore.

A big, recurring question facing us is whether the U.S. economy will avoid additional damage from DC.

The stock market's answer lately appears to be: Yes, we can...maybe.

----

*Iowa "Obama election" futures traded between limits of $0 and $1, with $1 being the payout if Obama won the election, so the price on any given day represented the market's assessment of his odds between 0 and 1 (or between 0% and 100%).

**A correlation of 0 indicates no observable statistical link. A correlation of 1 is the strongest positive link you can find. It means two numbers move in sync in the same direction. A correlation of -1 is the strongest negative link you can find. It means two numbers move in sync...in opposite directions.