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Obama fear?

By John Tamny and Rob Arnott

Published: October 30 2008 12:34 | Last updated: October 30 2008 12:34

The Dow Jones Industrial Average fell 12.5 per cent on October 29, 1929. Many commentators at the time and later suggested that stocks had simply become overvalued; the subsequent crash a return to normalcy after an overdone equity rally.

More realistically, investors were pricing in a very negative turn in the economic landscape that would enervate economies worldwide. The change had to do with trade policy, and specifically the looming passage of the Smoot-Hawley tariff that sparked economic isolationism around the world.

As the slow-motion crash in global markets has unfolded in recent weeks, during the run-up to an election, we find it shocking that the media has failed to explore the possible link between the forthcoming poll and the global crash in capital markets. Markets predict the future. When markets move, it is typically either in reaction to, or in anticipation of, news that changes our expectations for the future.

So, what exactly are the markets afraid of? Is it the evaporation of liquidity? The plunge in marked-to-market operating capital? Soaring leverage relative to a newly diminished capital base? These are subject to a vicious cycle of falling prices, leading to higher operating leverage, leading to forced deleveraging, leading to falling prices. But even that cycle starts and stops based on shifting expectations for the future.

What is the most significant geopolitical change on the horizon, that could perhaps alter our expectations for the future of capitalism? The forthcoming election, of course.

Much as Smoot-Hawley nearly 80 years ago foretold a bleak economic future, the presidential election predicts a significant change in terms of policy that many investors deeply fear. We suspect that there might be a direct link between crashing markets and the shifting political landscape, as Barack Obama and John McCain vie for the presidency. Mr Obama’s agenda is anathema to entrepreneurial capitalism. Protectionism and isolationism are central tenets of the Obama agenda. Neither is consonant with success in a global economy. Redistribution of wealth is central to Mr Obama’s populism. If we reduce the rewards associated with success and cushion the pain of failure, our incentives to work hard and innovate are diminished. Many observers decry the notion that the success of the wealthy “trickles down” to the poor. And yet, we are right now seeing that this cuts both ways: the pain felt by the wealthy today is “trickling down” to the restaurants, shopkeepers and businesses that keep our population employed.

Is it possible that the market crash is, in part, a direct consequence of the shifting polls that point to a near-certain Obama victory and with it his anti-capitalist agenda? Perhaps. But, how do we test the idea? We would need to compare the daily changes in Mr Obama’s electoral prospects with daily stock market fluctuations in order to test this hypothesis.

Enter the Iowa Electronic Markets. The University of Iowa runs a futures exchange in which people can invest directly in the outcome of the election. One of the futures contracts is called “winner takes all.” It closed on Tuesday at $0.152 for the Republicans and $0.857 for the Democrats. If you invest $0.858 on the latter contract and Mr Obama wins next Tuesday, you collect $1, for a 14.3¢ profit. This price is not the subjective opinion of some bookmaker. It reflects a consensus view of the thousands of people who invest on this exchange, with pricing reflecting their live minute-to-minute collective expectations. Tuesday’s close suggests that Mr Obama has roughly an 85 per cent chance of winning next week, and McCain has a 15 per cent chance.

We can compare the daily close of this “futures market” with the daily performance of US and International stocks, using the S&P 500 and MSCI EAFE as our measures for stock market performance. They seem closely linked, with even many of the daily wiggles aligned. There is an impressive 20 per cent correlation with the daily market moves, right on up through yesterday’s rally, which coincided with a 10 per cent rise in Mr Obama’s estimated odds of losing.

Of course, correlation does not mean causality. Are Mr Obama’s soaring prospects for victory causing global markets to crash? Or is the global market crash driving voters into Mr Obama’s camp? Is the global recession and liquidity crisis both creating the market crash and setting the stage for an Obama victory? Statistics alone cannot answer these questions. But many readers may be surprised to learn that they support all three.

There is more than a 20 per cent correlation between today’s market action and the changes in Mr Obama’s prospects, with markets falling when these prospects improve. If we ask whether a drop in stocks today presages an improvement in Mr Obama’s prospects tomorrow, or whether an improvement in these prospects today presages a falling market tomorrow, we get a still-impressive correlation of over 10 per cent in both cases. Clearly, we would be naïve to reject any of these hypotheses as a contributing factor in the current state of affairs. This simple test suggests that we should not blame the market crash solely on the mistakes of the Bush team, any more than we should blame it singularly on Mr Obama’s anti-capitalist rhetoric.

We assume that Mr Obama wants to see the market soar in reaction to his probable victory next Tuesday. If he wins, as seems highly likely, we want his presidency to be a success for us all. If he wants to assure a strong market in the wake of his probable election, he may wish to temper his protectionist, isolationist and redistributive rhetoric. A few words of respect for the merits of global competition would go a long way towards soothing the markets and ending this current vicious cycle. How about it, Barack? Care to say something nice about capitalism in the next few days?

John Tamny is editor of RealClearMarkets and a senior economist at H.C. Wainwright Economics. Rob Arnott serves as chairman of Research Affiliates, an asset manager based in California

Copyright The Financial Times Limited 2008

"FT" and "Financial Times" are trademarks of the Financial Times.

© Copyright The Financial Times Ltd 2008.

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There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved. - Ludwig von Mises

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