Tuesday, September 21, 2010

A writer for Time magazine thinks GOP gains in November could be bad for the stock markets, basing his analysis on a review of past mid-term elections.

Well, aside from agreeing that, in most situations, anything 'could' happen, his looking at the past to predict the future is a pretty close to a 100% flawed approach.

Stock markets go up only when there are more investors looking to buy stocks than there are investors wanting to sell. And this happens only when the would-be buyers think stock prices are going to go up even more in the not-too-distant future... which, if you follow the argument, means the first wave of buyers think there is going to be an even larger group of buyers in the not-too-distant future... and, the cycle goes on until those holding stock start fearing that there won't be buyers willing to pay higher prices and thus start to sell.

Thus, stock prices are based on investor anticipation of what is going to happen in the future. While their feelings about the future may in part be driven by what has taken place in the past, no one really buys or sells stock based on the past. (this is similar to employers who reduce staffing levels; their actions are not based on what happened in prior periods as much as it is driven by their fear that future revenues won't be enough to cover their current staffing levels)

So it is far less useful to look to the past to predict what could happen next year than it is to look at how investors are likely to react to the GOP taking over one or more houses of Congress. Put simply, if investors think the Democrats losing control is going to be good for the economy, they're going to start buying stocks... and, conversely, if investors think the GOP taking control is going to be bad for the economy, then they're going to be looking to sell stocks.

My guess is that investors will react positively to GOP gains and proportionally so, investors will be more enthusiastic if the GOP takes control of both houses than they will if the GOP merely reduces the Democrat's margin of power.