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.

~~~

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.

Category: Apprenticed Investor, Investing, Politics, Psychology

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

10 Responses to “Investors Should Ignore Economics & Politics”

  1. zell says:

    I wish the Fed would accept responsibility for valuation so we’d have less highs and lows which are so socially destructive. The Fed both ignores valuation when the high is on , and then distorts valuation when it attempts to repair the damage it has wrought. that’s not to say there is not a business cycle. Bernanke has one of the economy’s loudspeakers , successfully using his emphasis on increased transparency, to regularly reinforce proposition that there is nothing to fear as long as he is in control.

  2. capitalistic says:

    Great write up. Politics and economics affect asset prices due to investor bias. If one were to eliminate the sentimental premium or discount of an asset, there will always be “value” – long or short.
    Look at Apple. On a basic cash flow basis, Apple is undervalued. But try telling that to the media and/or institutional investors who are probably upset because they bought Apple above ~$500.

  3. LauraS says:

    In regards to what you say about the economic data:

    I agree, there are big inconsistencies, and sometimes data collection serves no real meaning. The most typical example is GDP, which itself does not provide any useful information. What exactly can some person or even enterprise take from the information that there is lower or bigger growth. Many times, this growth proved to be a bubble financed by stated (I expect Brazil to be the near future example).

    Other thing you mention is the discrepancy of stock market growth and recession. And in my opinion, you are right again. Look at the third richest person in the world Amancio Ortega with his retail chain ZARA. It is being operated from Spain, and it is a huge success. Spain and its economical situation did not bring its stocks down. And there are many other successful companies in countries in recession.

    You say it all in the last paragraph: “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.” I´m observing the Vancouver RE market for a long time and I could tell from the data that something is going to happen. But it took another two and half year to really see some dropping in the insane high prices ( February Market Report). What I took from this experience was the knowledge about the irrationality of markets and actors participating in them. This is by itself a proof that any model can be highly confusing, especially in a short time duration.

    ~~~

    BR: Exactly.

  4. Lee Adler says:

    “These are minor and noisy fluctuations, often reflecting flaws in how the data are collected or seasonally adjusted.”

    Precisely. The appearance of low correlation is due to the inaccurate way Wall Street economic pundits and media report the data. First they use seasonally adjusted data, which is fictional. Second they report month to month comparisons, which are meaningless.

    Joe Granville said many years ago, “What does the stock market have to do with the economy? Absolutely nothing.” In the short to intermediate term, he’s right, as is Barry, but the broad trends of both over the sweep of time do correlate fairly well. When they start to diverge significantly, it’s time to be alert for change.

    Friday’s industrial production release is a case in point. Industrial production and stock prices are following the Fed’s wishes. http://wallstreetexaminer.com/2013/03/16/industrial-production-still-below-2007-but-trend-is-up-following-massive-fed-pumping/

  5. Larry says:

    Thanks for a good article telling us what is totally counter-intuitive. As an active investor I spend (waste?) way too much time trying to keep up with all the economic reports and political developments. I concur with the idea that “valuation is a much more important component for investing than people believe”. Since US equity PE ratio is roughly 14 to 15 times current annual earnings, one must conclude that the market is fairly valued, despite the apparently over-exhuberent rally of the last four months. Might as well sit tight in a good balanced fund or with a well-balanced portfolio and go out and enjoy life instead of pissing away my retired life trying to track every little nuance in economics or politics. Is there a chapter of financial Blog-readers Anonymous that I can go to?

  6. Larry says:

    Thanks for a good article telling us what is totally counter-intuitive. As an active investor I spend (waste?) way too much time trying to keep up with all the economic reports and political developments. I concur with the idea that “valuation is a much more important component for investing than people believe”. Since US equity PE ratio is roughly 14 to 15 times current annual earnings, one must conclude that the market is fairly valued, despite the apparently over-exhuberent rally of the last four months. Might as well sit tight in a good balanced fund or with a well-balanced portfolio and go out and enjoy life instead of pissing away my retired life trying to track every little nuance in economics or politics. Is there a chapter of financial Blog-readers Anonymous that I can go to?

  7. GeorgeBurnsWasRight says:

    Well, maybe completely ignoring politics isn’t a good idea, at least not if you live in Cyprus.

  8. slowkarma says:

    Barry wrote:
    “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.”

    Then it would seem to be quite a viable investing strategy to simply do your day job and plug your savings into bonds, and no stocks at all, until the next inevitable recession/correction, which are pretty readily identifiable. And after you’re in (after each recession) simply leave the money there — perhaps in an index fund — until retirement. If you did this first when you were 35, you would have on average about six of those buying opportunities by the time you were 60 or so. It wouldn’t be much fun, but each tranche of cash would earn you more or less 5% a year, on top of the bond earnings, with virtually no risk. Further, except immediately after a correction, you would always have cash on hand for emergencies.

  9. Larry says:

    slowkarma, Great idea to wait it out and only buy equities in bulk after a 20% + drop due to recession or other crisis. A corollary to that approach is refraining from new equity purchases during times like now (after a 4 year run-up of over 130%). Low furation fixed income pays very little while you wait for the next recession, but it sure beats taking a big loss. Thanks.

  10. [...] I have been guilty of violating this principle that is taught by Barry Ritholtz. I recently read his great article that analyzed the impact that politics and economics has on investment community. It was [...]