Friday, March 06, 2009

He's worse than we thought, or, the second derivative is negative 

In October I wrote a post titled "The Obama Discount" which included the graph to the left. This compared the InTrade price on the Obama wins contract with the closing price of the Dow, on a daily basis. The regression line is drawn and its equation appears on the lower left hand corner. If you were to set the probability of an Obama win at 100% -- which it was on November 5, 2008 -- you would get a closing price on the Dow of 7,708.11.

Now obviously that's not a great measure of what the market thought of candidate Obama. It extrapolates the line well past the data, which we teach our students not to do. The Dow closed on November 5 at 9,139.27, down almost 500 points that day. It went down more the next day and never rose above that mark (only above 9000 on the close on January 2 and January 6.) On January 20, the market closed at 7,949, certainly within the margin of error of that 7,708. But again, that could be just coincidence.

Now the stock market is a leading indicator. As much as the Obama administration would like to say the market is not a statement on his economic leadership, the Dow has been used to predict business cycle troughs, with average length between bottom of the stock market and bottom of the economic recession about five to six months. If his leadership is supposed to have caused a recovery, it hasn't yet.

If anything, the movement down from the beginning of this administration's inauguration to now is a statement of what the market thinks the economy will do this summer and fall. One could say that the fearmongering of the early days of Obama's term may have provided more information to the market and talked it down. Its movement of late though, with Obama having stopped being President Eeyore, can only be ascribed to expectations on the basis of the stimulus package's passage and the uncertain future of the financial plans. The market's drift downward today, in the presence of an employment report that had no surprises, is not a statement of disappointment about the nature of the current economy. (I haven't done an exhaustive literature review, but I am pretty sure there isn't evidence on reverse causality from the economy to the Dow.) It is the increasing realization that James Pethoukoukis' pronouncement last October, which got me to dry that first graph, was correct:
I find it hard to believe that fears about a deep recession are suddenly dawning upon investors and thus are solely responsible for kneecapping the market. I've been hearing such dire forecasts for weeks from top Wall Street economists, and I really think they're already baked into the cake. (And credit markets actually look like they are finally picking up a bit�a plus for stocks.) So with that perception locked in, maybe the future political landscape is finally playing a greater role in the minds of investors, especially with polls showing a possible landslide Obama win and big Democratic congressional majorities. Is it really more plausible to suggest no effect whatsoever from a possible once-a-generation, political sea change, especially one that moves away from the winning economic formula of the past 25 years ? Not even a smidgen of worry? C'mon, now.
To paraphrase the immortal words of Denny Green, Obama is who we thought he was, and he won anyway. The market, that great processor of information, has figured this out.

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