With its reflexive drop overnight and continued weakness Friday following the failed “Plan B” maneuver by House Speaker John Boehner, the stock market has once again shown exactly the kind of thing it’s not good at discounting in advance.
Not politics in general, nor the influence of fiscal matters on the economy, but close-combat policy disagreements whose progress and outcome are determined by the unknowable intentions and calculations of a small number of individuals.
Markets are best at discounting events and other phenomena influenced by a broad and diverse set of informational cues. This is the vaunted “wisdom of crowds” that makes a large collection of self-interested actors better than any one person at predicting everything from the number of jellybeans in a jar to the winner of Best Supporting Actress.
When Collective Predictions Fail
This logic drives “prediction markets” such as Intrade, which have proven keen at foretelling election results and entertainment awards. Yet Intrade’s bettors were proven woefully wrong earlier this year when they collectively predicted Obamacare would be deemed unconstitutional by the Supreme Court.
Far from undermining the reliability of prediction markets in most situations, though, this proved the sort of thing these markets have always been known to be poor at: handicapping. The Court’s vote hinged entirely on Chief Justice John Roberts’ unexpected turn of legal reasoning, and was known to a mere handful of people sworn to secrecy. The crowd, in this instance, had no edge because there was not a diffuse set of important inputs available to process.
(Some will object that the stock market failed to discount the broadly predictable, and poll-predicted, re-election of President Obama. But stocks perfectly tracked Obama's Intrade re-election odds all year, and the pullback after Election Day, driven largely by the pent-up tax-hike panic of retail investors, was quickly reversed).
Which brings us to Thursday's vote and the market’s response to it, a sudden 2% plunge as Boehner scrapped a vote on his limited tax-relief bill for sub -$1 million earners. That's a pretty severe reduction in the market's estimate of the value of all future corporate cash flows based on the failure of a mere tactical gesture in one house of Congress.
A Lack of Insight
The market's inherent lack of insight into the negotiating priorities and ulterior motives of the handful of politicians who hold the fate of an agreement is a big factor -- but not the only one. This certainly caught stock traders flat-footed on the first failed financial-bailout vote in 2008 and during last year's debt-ceiling horn-locking in Congress.
There's a school of thought that holds that stock investors, prone to distraction by plausible human forecasts and lots of corporate storytelling, are particularly slow to fixate on the essential market-moving probabilities.
No doubt, there is also a disconnect between Wall Street and Washington thinking at work. With the on-paper differences between the public negotiating proposals of Boehner and Obama appearing reconcilable, finance types are quick to assume a split-the-difference outcome.
A deal that averts the automatic spending cuts and higher taxes became priced into the market as a baseline assumption weeks ago. In truth, the market would probably prefer the narrowest possible bargain, which would avert the "cliff" without quickly withdrawing fiscal support for the economy or upending the tax code.
Such a resolution would allow the economy to chug along at an OK clip, release a bit of pent-up demand for business spending and allow the deficit – already shrinking as a proportion of the economy – to recede in a measured way due to cyclical improvement. Investors say they want federal-budget chastity, but the market as a whole probably doesn’t want it soon.
The S&P 500 index’s 7% rally from mid-November into this week was partly fueled by an assumption of such a deal surfacing, and t his set the market up for disappointment almost regardless of how the Capitol Hill sparring went. So far the damage hasn’t much impaired the five-week uptrend, nor has it offered any real clues as to how 2013 will go.
But stocks’ demonstrated inability to discount the path that political brinksmanship will play out with any reliability implies that we may not have seen the last spasm of investor frustration in what is generally meant to be a calm and peaceful end to the year.