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Confusing Cause & Effect

Posted By Barry Ritholtz On July 26, 2004 @ 2:11 pm In Finance,Politics | Comments Disabled

As the indices flail about, groping for a bottom, the search for an explanation as to what ails the markets continues apace. The latest potential culprit: Politics! The WSJ [1] quoted a political analyst today, who observed that:

“I would consider that uncertainty around the outcome of the presidential election [as] one of the major influences on the skittishness in the U.S. market.”

This perspective gets the cause and effect relationship exactly backwards. Unfortunately, causative errors are an all-too-common analytical blunder when reviewing market data. Given the blaring headlines and search for certainty in an uncertain world, confusing cause and consequence is a regular occurrence. This is a perfect example of that foible.

Indeed, we often see this in misguided attempts to explain the chaotic machinations of markets’ complexity: When the indices are vulnerable – during mutual fund outflows, fading M2 supply, or excessive bullishness – we see everything but those factors getting blamed.

Indeed, I have yet to figure out why it is that some terrorist attacks “roil the market” while others (with the same appalling body count) get shaken off. The horror of the situation is the same, the tragic waste of life no different; Yet the markets somehow have totally different responses. Is it, perhaps, because these headline events are not really what is causing the markets to shudder and shake?

Returning to politics: Markets are not skittish because the incumbent is in trouble – that’s getting it backwards, a perfect example of confusing cause and effect. Incumbents are in re-election trouble because the future discounting mechanism of the markets is incorporating a slowing economy into its pricing. While the markets do not always get it precisely right, they do so often enough that a weakening economy-which hurts equity prices-invariably negatively impacts an incumbent’s re-election chances.

The Journal [1] notes:

“The most talked-about political worry is Mr. Kerry’s tax policy, which, according to his policy advisers, calls for undoing the recent cuts in capital-gains and dividend taxes for investors with incomes greater than $200,000.”

Is this what’s really been worrying the markets?

Unless there is total election shocker, there will be at most a divided government, with the House of Representatives [2] unlikely to change leadership. This would force both branches of government to move towards the center, and govern moderately – an arrangement under both Presidents Reagan and Clinton that worked out quite well for equities.

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URL to article: http://www.ritholtz.com/blog/2004/07/confusing-cause-effect/

URLs in this post:

[1] WSJ: http://online.wsj.com/article/0,,SB109059250479372255,00.html

[2] House of Representatives: http://www.house.gov/

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