Wall Street and US elections

There are two pieces of Wall Street lore about market performance around presidential elections that have passed their sell-by date but which continue to float around. They are:

–the last year of a presidential terms is a good one for stocks; the first year of the new term is a bad one.

The idea behind this is that the incumbent president would successfully pressure the Federal Reserve into a looser-than-necessary money policy in the runup to the election. This would give an artificial boost to the domestic economy, enhancing his reelection prospects. This extra stimulus would be reversed after the election, slowing the economy down in the first months of the new term. Gerald Ford’s refusal to follow this custom is often cited as the reason he lost the 1976 election to Jimmy Carter.

With the exception of Donald Trump, who has continually pressured the Fed to loosen money policy throughout his term, this no longer happens. I’m not 100% sure why. My leading candidates: the world is a much more complex and mutually integrated place than it was a generation ago, so it’s not so easy to use the domestic money supply to give the economy a pre-election jolt; over the past quarter-century there have been a succession of crises, from Y2K/Internet bubble to 9/11, to the Great Recession, to Trump’s wrongheaded tariff wars, to his coronavirus bungling, that have dwarfed any monetary tweaking the Fed might contemplate .

In any event, there’s no reason to believe that the world economy will be weaker in 2021 than it is now or that a post-election tightening in money policy is on the cards.

–Republicans are good for stocks, Democrats are not.

The idea here, from a generation ago as well, is capital vs. labor. A high-level Republican goal is to protect the accumulated wealth of its country club backers. This means having low taxes and low inflation. The Democrats, on the other hand, represent workers whose chief asset is their labor. Their main economic goal is to obtain real wage/benefit gains. The inflation that results doesn’t hurt them because they have no wealth to begin with. And it makes them better off by eroding the real value of the goods and services they need to buy from Republicans.

Again, the class warfare that defined the old Democrat/Republican battle lines is mostly gone. As a former work colleague of mine was already writing thirty years ago, neither party has a relevant economic program for today’s world. Ironically, despite its business roots, the current Republican administration is supported mainly, I think, by workers disenfranchised through the demise of heavy industry in the US (and ignored in a worst-in-the-world fashion by both parties). And the head of the party is a stunningly inept businessman who continues to do enormous economic damage to the country.

A more reasonable worry about the election might be that a Democratic administration would partially reverse the corporate income tax cuts of 2018. That might lead to after-tax results from the S&P 500 next year being, say, 3% lower than expected. 3% is not a big number, though. And there might be positive effects on growth from reopening the borders, a more intelligent approach to the potential threat from China than shoot-yourself-in-the-foot tariffs, removal of some of the white racist tarnish of the American brand abroad…

two common market fallacies

market cap/GDP

I was reading an article on Yahoo Finance the other day that cited what it claimed was a Warren Buffett rule to gauge whether the US stock market is under- or overvalued. The idea is that if the total market cap of US stocks exceeds annual GDP (of the US) then stocks are overvalued. If market cap is less than GDP, stocks are undervalued.

On the surface, this sounds like it might make sense, since it is the US stock market, after all. And the health of the Treasury bond market is tied to the vigor of the US economy. Also, the idea was big in the 1980s, when market cap/GDP was used by Americans and Europeans as a rationale for not becoming involved in the Japanese stock market during a decade-long domestic economy boom there.

Two issues this idea ignores:

–multinational companies. In the case of the US, a good guess is that half the earnings of the S&P 500 come from outside the US. In fact, a very simple but effective way of approaching structuring a portfolio in the US market is to ask whether the US economy will likely do better than the rest of the world in the year ahead or worse. In the first case, the portfolio should overweight domestic-oriented stocks; in the second, internationally-oriented.

–how much of the domestic economy is publicly traded. In the case of the US, big sectors like real estate and housing have little representation. Germany, whose market cap has seldom, if ever, exceeded half of the country’s GDP, is the biggest counterexample for the cap/GDP idea. Two reasons: almost nothing is listed in Germany, and German citizens have historically had little interest in stocks.

For the record, I can’t imagine Buffett thinks this.

strong stock market = strong economy

Typically, this is the case, in my experience. But there are exceptions, like Mexico in the 1980s–and Germany almost always. In today’s US, it’s easy to see, by comparing the global NASDAQ with the US-centric Russell 2000, that stocks are strong in spite of weakness in domestically-oriented issues. In fact, somewhat like Mexico back then, the US market is underpinned by the near-zero interest rates made necessary by our extreme economic weakness.

A side note: over the past three months, the R2000 (+22.7%) has held its own with NASDAQ (+24.5%). Both have far outdistanced the S&P 500 (+17.5%). Why the R2000 strength? Three possible reasons (translation: I don’t know): counter-trend rally; the worst of the pandemic is already baked into R2000 prices; anticipation that Trump will not be reelected. My guess is some combination of the first two. I think it’s too early to be trying to figure out the election, although belief in four more years of Trump dysfunction should translate into shorting the dollar and the R2000.