Scott Sumner  

What do markets tell us about US Presidents?

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In my comment sections I see a lot of speculation about the rising stock market, and what it's telling us about the policies of the next administration. I'm on record as strongly favoring the use of market indicators to evaluate the effect of policies. But before doing so, a few caveats:

1. It's easier to use market indicators where you have a real time response to a discrete policy move---such as an unexpected increase or decrease in the fed funds target. Markets respond within seconds.

2. It's important to keep in mind that stock prices can at best tell us something about the likely economic impact of a new administration, not it's overall impact. Thus if an administration increases the risk of nuclear war from 0.4% to 0.8%, that's a really bad thing, but it won't significantly impact prices, partly because the probability is so low, and partly because even money may be worthless after a nuclear war.

The same is true if a new President emboldens the Russians to slaughter 1000s of Syrians, or if they reduce civil liberties, or stop trying to address global warming, or harass illegal immigrants, or 100 other policies that some might object to for non-stock market reasons. Lots of bad things don't impact the stock market.

3. There are policies that might help the stock market without necessarily helping the economy, such as reducing bank regulation, or sharply cutting corporate income tax rates.

Having said all that, I do think that a corporate tax reform that reduces rates to 20% and closes loopholes would help the economy. Even better if they put debt and equity on a level playing field. (Debt is currently taxed more lightly than equity, which is sort of bizarre given that debt crises such as 2007-09 seem to hurt the economy much more than equity crashes like 1987 and 2001.)

I also think that reducing regulations on business is generally a good thing, with the possible exception of environmental regulations, where there are clear externality concerns. In addition, there is evidence beyond the equity markets that growth expectations are rising. For instance, long-term real interest rates have risen in recent weeks, as has the US dollar. Unfortunately even those facts allow for two alternative interpretations, either fiscal stimulus or faster supply-driven growth. Because I believe the Fed would offset the demand-side impact of fiscal stimulus, I lean toward the supply-side argument. But it's obviously still a debatable point.

To summarize, I strongly favor using market indicators as tests of the likely impact of policy. But always be aware that it's hard to get a "clean" test of any theory, as there are usually multiple possible interpretations. The best tests occur where there are repeated, discrete, policy announcements that occur at a point in time, such as fed funds rate announcements. And even there, you need to compare the announced value to the predicted value in the futures market.

One final point. You need to be intellectually consistent. The stock market nearly tripled under President Obama. I doubt even his supporters would give him all of the credit for that, indeed he's been hard at work trying to redistribute wealth from the rich to the poor. But that means that if a tripling of the market may or may not reflect Obamanomics, it's pretty hard to be certain that a less than 10% increase reflects Trumponomics. It may, but we'll know more when the actual policies are announced, and we see how the stock market responds.

PS. The EMH tells us that the Obama bull market cannot be written off as a mere "rebound" from its depressed 2009 levels.

PPS. I encourage commenters to avoid getting off track with my non-economic problems cited above. I don't know enough about Aleppo to argue the case; my point was that you could imagine some non-economic issues than are nonetheless important. You could replace Aleppo with abortion, pot legalization, kidney sales, or many other issues that involve difficult ethical judgments. There's more to life that stock prices.

Tyler Cowen has a good article on which stock indices to use for which questions.




COMMENTS (7 to date)
James writes:

"PS. The EMH tells us that the Obama bull market cannot be written off as a mere "rebound" from its depressed 2009 levels."

Scott,

No it doesn't. The EMH tells us there is no better forward looking estimate of future prices than current prices. That is all it says.

The EMH does not tell us that prices in 2009 or today are error free estimators, or that the error term doesn't go through episodes of positive or negative serial correlation, although it does say that these episodes are not predictable in advance or even identifiable in real time. Importantly, the EMH does not say anything about what we can say with the benefit of hindsight.

If you have a different theory which is even bolder than the Fama/Smuelson version of the EMH, that's fine but please don't call your theory the EMH. That name has been taken.

Scott Sumner writes:

James, I think you misunderstood what I meant by "rebound". I meant the increase was no less impressive for being from a rather low base. A rebound is not inevitable just because prices previously fell.

Andrew_FL writes:

Externality concerns do not bear on the expected growth impact of reducing environmental regulations, however.

James writes:

Scott,

I think you misunderstand the current consensus among the leading EMH theorists.

A rebound is not inevitable just because prices previously fell but it is a statistical fact that returns are, on average, higher after declines and the greater the decline, the greater the subsequent rebound.

If you do not want to believe me, feel free to consult Fama and French's published work on the "anomaly" they call long term reversal.

Roger McKinney writes:
stock prices can at best tell us something about the likely economic impact of a new administration

Well it can really only tell us what the consensus view is from investors. They could be wrong. You also have to look at volume. This time of year volume tends to be low so a few trades can have an excessive impact. It appears that those investors active in the market recently are paleo-Keynesians in that they think fiscal policies will rescue the economy. I'm betting they're wrong.

The great Austrian economist Ludwig Lachmann called the stock market a futures market because it provides information on investor expectations about the future. Mises considered the stock market to be capitalism's most important institution for similar reasons.

The stock market allocates capital by taking it from failures and giving it to successes. And it coordinates economic activity by revealing expectations about the future.

Scott Sumner writes:

James, That's fine, I'm aware of all that---Shiller has similar findings.

But what was the expected return over the next 5 years (according to those models), as of March 2009? And then tell me what the actual return was. I think you'll see my point.

Roger, You said:

"It appears that those investors active in the market recently are paleo-Keynesians in that they think fiscal policies will rescue the economy."

I very much doubt that. Did investors expect the austerity of 2013 to cause a recession?

TravisV writes:

David Glasner has a new post on this topic: "The Trump Rally"

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