"Kee" Points with Jim Kee, Ph.D.

Overall the economic news was pretty good last week. In the U.S., nonfarm payrolls increased by 171,000, which was above consensus. That puts the year-to-date average at 156,000 jobs per month, not enough to ratchet the unemployment rate down, but consistent with slow (1%-2%) growth. Last week’s ISM manufacturing and non-manufacturing indices also registered expansion, with the manufacturing index increasing slightly and the perhaps more important non-manufacturing (services) dipping slightly (but still in expansion territory). As far as Hurricane Sandy is concerned, I expect the impact to produce a modest decrease in GDP followed by a roughly equivalent-sized bounce during the rebuilding phase. Elsewhere, China’s purchasing managers index suggests that the world’s second-biggest economy is rebounding moderately, (Financial Times), and recent GDP data in the U.K. suggests that it too might be turning the corner (Wells Fargo Securities).

But of course, all eyes are on the U.S. elections this week. Rather than pretending to be able to predict the outcome, I view situations like this as a way to gauge the validity of more scientifically-oriented predictive models. In particular I’m referring to PollyVote, which combines polls, index models, econometric models, the Iowa Electronic Markets, and experts’ judgment. It was developed in part by Wharton’s Jon Scott Armstrong, who is generally considered to be one of the world’s foremost authorities on scientifically-valid forecasting principles and models. Right now, PollyVote has President Obama winning with 51.4% of the vote. That’s what I have consistently seen across models over the past six months: an Obama win, but with a narrow enough margin to make it almost a toss-up. That doesn’t seem helpful, but what the scientific state-of-the-art model is telling us is that it will be an extremely close election.

What does a close election mean for stocks? J.P. Morgan just published a research report showing that, following close elections, equity markets rallied over 3%, and they rallied over 6% if the challenger wins. Their explanation for these facts is that uncertainty eases following a close election (favoring equities), and that a close election suggests a degree of dissatisfaction with the incumbent party and therefore “incremental optimism if the challenger wins.”

Once the outcomes are known, I’ll probably do an analysis of likely winners and losers under various scenarios, but as I have mentioned in the past, markets tend to move quickly and price these things instantaneously. You really have to predict things before they are known or occur, but as Harvard business historian Richard Tedlow put it, “In fact, we learn from history that we cannot even guess at what is over the horizon.” That’s why you diversify. You can know that safe bonds serve as an offsetting hedge to stocks during market downturns. And, you can also know that exposure to stocks is necessary for real upside in the long-run. Of course, given the recent decade, the “long equities” line is less enthusiastically received, especially coming from perceived “perma-bulls” like Jeremy Siegel, who first wrote Stocks for the Long Run in 1994, which argued from historical trends that equity exposure was a must. Needless to say, Siegel’s star has fallen during the recent crisis, giving way to new gurus like Pimco’s Bill Gross. In light of this I think Siegel’s response to recent criticisms by Gross would be of interest to Kee Points readers (Wisdom Tree):

“Finally, I had a chuckle when Gross referred to my Stocks for the Long Run as an ‘ill-timed book affirming the equity cult.’ My book hit the stores in May 1994, and the return on stocks since then has been in excess of 8.3% per year, with a real return very close to the historical average. What was in fact particularly ‘ill-timed’ was Bill Gross’s much ballyhooed prediction entitled ‘Dow 5,000,’ which he published a few weeks before the bottom of the 2002 bear market, when the Dow Industrials was ready to run from 7,500 to over 14,000.”

I imagine these two will be going at it far into the future!