Logical Reasoning Errors: The Dow Election Year Cycle

I find it utterly fascinating that Human Beings frequently engage in the sloppiest of thinking and critical analysis. Aren’t our big fat brains what separates us from the lower animals? As a person who many years ago taught classes on logical reasoning and critical analysis (LSAT and GMAT prep), its always amusing to see very basic logic errors in print. Especially the Wall Street Journal.

While nearly everybody continues to confuse cause and effect between the markets and politics, an astute reader sent me this chart below:

Click for larger graphic
dow_election_year_cycle
chart courtesy of Ned Davis Resarch

I interpret this chart not as the market obsessing about who will win the presidential election in November; Rather, it reveals that marlets are discounting the increasing possibility of an incumbent defeat and a challenger victory.

In particular, look at the bottom line on the graph above, showing what markets look like on average when the incumbent party (either Republican or Democrat) loses the Presdiential election. Mark Twain is alleged to have said “History doesn’t repeat, but it sure does Rhyme;” On the chart above, history is not repeating precisely, but which line “rhymes” the most with this year’s market conditions?

kerry_house_futures Which brings me to Eric Engen’s Op-Ed in Wednesday’s WSJ — Kerry Up, Markets Down. Engen puts forth the notion that as Kerry rises in the polls, he is causing. There were simply too many errors and misstatements to fisk the entire piece, but we can at least look at the terribly flawed logic involved.

A quick glimpse at the chart at right appears to show an inverse correlation — especially since March 2004. Correlation, however, is not the same as a causal relationship; The Abu Ghraib prison torture scandal was breaking about that time (ironically, the WSJ was the most aggressive investigators of that debacle). As this politically embarrassing episode unfolded, it had scared the Hell out of a lot of investors — so until the dust settled, they moved to the sidelines. This move out of the markets was rather reminscent of the pre-Iraq war period, first quarter of 2003.

It also, not coincidentally, had the effect of a) lowering the incumbent’s approval ratings; and b) improving the challenger’s chances.

In making this rather slipshod analysis, Mr. Engen, makes a classic causative error: He confuses a correllation in time with a causal relationship. Instead, he should have recognized that the same underlying factors led to BOTH EVENTS: Kerry’s rise, and the markets fall.

Minor Data, Weak Correlation
Additionally, if we take a slightly more detailed glimpse at the author’s prime data source, we see how foolish his methodology truly is: Engen relies in large part on the Iowa Futures markets to support his assertion that as Kerry’s chances for election improves, the markets then weaken.

Put this into context: The total dollar amount invested in this market (according to one of the Profs at Iowa I spoke with) is at present a grand total of $15,800.

Fifteen thousand, eight hundred dollars being played with primarily by a group of under-graduate and graduate students at Iowa University. From this “prediction market,” the author deduces the outcome of the $7 trillion capital markets in the United States.

Back on July 24, 2004, we asked “Is the market reacting to the incumbent’s chances?” Even a brief review of a detailed chart, fails to convince an objective viewer of any true cause and effect relationship between the two.

If you want additional insight about the prognosticating accumen of the prediction markets, consider this last detail: The Iowa Futures had predicted a Howard Dean landslide in the Iowa primary. You may recall that he got clobbered.

Any other questions?

UPDATE: August 14, 2004 9:21 am
Here’s an interesting comparison of the Leading Economic Indicators and the major indices.

Sources:
Confusing Cause & Effect
July 26, 2004

http://bigpicture.typepad.com/comments/2004/07/confusing_cause.html

Confusing Politics With Economics (subscription only)
Barry Ritholtz
The Street.com, 7/28/2004 2:30 PM EDT

http://www.thestreet.com/p/_rms/rmoney/barryritholtz/10174814.html

Iowa and Prediction Markets
January 24, 2004

http://bigpicture.typepad.com/comments/2004/01/iowa_and_predec.html

Kerry Up, Markets Down
By Eric Engen
August 11, 2004; Page A10

http://online.wsj.com/article/0,,SB109217833883588077,00.html

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