The Dow had its worst day of the year yesterday, falling 313 points. Market observers were quick to blame the Obama re-election and concern over the fiscal cliff for the decline. Some meekly mentioned concerns over the Greek austerity bill being voted on (it passed), or other European worries such a German GDP being lower than expected. This was not the worst news day of the year from Europe, and did not merit a 300 point sell off, which would seem to indicate that something else is at play here.
Obama’s re-election was not responsible for yesterday’s market decline. There is a theory in academic finance called the Efficient Market Hypothesis (EMH). In its most basic form, this states that markets are efficient and react almost instantaneously to any new information, making it impossible to beat the market using public information. President Obama was largely expected to be re-elected. On Tuesday, when the market rallied, Obama was given a 70% chance of winning by peer-betting website InTrade®.
Since Obama was expected to win, the Efficient Market Hypothesis says that the market had already factored in an Obama victory to all stock prices. This adjustment has been made gradually over the last few months as Obama has appeared more likely to be re-elected. The Republicans were also expected to maintain control of the House of Representatives and the Democrats were expected to maintain control of the Senate.
This is exactly what happened, the status quo was preserved. Since this was expected, the most obvious consequence, the looming fiscal cliff, was also expected. Thus, according to the Efficient Market Hypothesis, stock prices have already accounted for the looming fiscal cliff and the preservation of the status quo. Then why was the market down 2.4% yesterday? The answer is investor psychology.
The chart above shows the S&P 500 Index (SPX) and the Dow Jones Industrial Average (DJIA) over the last month. As it became increasingly apparent that Obama was going to be re-elected, the EMH would say that stock prices adjusted over the last month.
Some stocks were clear winners from the Obama re-election; namely green-tech companies. There were also clear losers: financial service firms, energy companies, healthcare companies and high yield dividend stocks. As the stocks of companies that were clear losers were sold, they dragged down the market which incited widespread, but irrational, fear. The fundamentals of the companies have not changed overnight. The fiscal cliff dilemma facing the nation has also not changed overnight. Investors panicked, but wrongfully so. The day after Barack Obama was elected in 2008, the stock market was down 5.1%. His first term in office was highly successful for equities however, as the stock market returned over 95% from his inauguration to mid- September, largely as a result of the three rounds of quantitative easing.
Obama was inaugurated in January of 2009, shortly before the market bottomed out.
The sell-off in the markets will be temporary for three main reasons. First, the Chicago Options Board Market Volatility Index, of VIX, was relatively muted. This VIX measures volatility in the market and is used as a proxy to gauge fear. According to Randy Frederick, Managing Director of Active Trading and Derivatives at Charles Schwab and Co, this may indicate that the pull-back will be short lived.
The other two reasons are less technical and slightly more speculative. Secondly, Barack Obama has two wealthy intelligent hedge fund managers backing him in George Soros and Warren Buffett. Both man possess an intimate knowledge of the economy and believe in President Obama and in his plan. They are also both shrewd investors who are known for buying good companies for bargain prices when everyone else panics. At the end of the quarter when Soros and Buffett file their 13Fs disclosing their new positions, it would not be surprising if it is revealed that they have added to some of their positions amidst the sell-off. This disclosure would return investor confidence to the market and spur the market higher. The third reason why this pull back is temporary is because both the House Republicans and Obama have acknowledged that the close popular vote has given politicians a mandate from the people to compromise. Partisan bickering aside, economists are united in predicting that if a compromise is not reached, the fiscal cliff will send America into another recession. An investment in equities now is a bet that Washington reaches a compromise before December 31.
Wondering how to trade this pullback and subsequent recovery? Look for strong companies at attractive valuations. Warren Buffett is regarded as the greatest investor of all time. Some companies he is currently invested in include: Walmart (WMT), Kraft Foods (KFT), Proctor and Gamble (PG), Coca-Cola (KO), Phillips 66 (PSX), and National Oilwell Varco (NOV). Buffett’s largest holding is Coca-Cola, and his two most recent purchases are in Phillips 66, and National Oilwell Varco. Both PSX and NOV are oil companies which were down heavily yesterday after the Obama victory. Buffett is famously patient and invests with a time horizon of decades, not days. Look for Buffett to attempt to add to his recent positions in oil companies now that energy stocks are being sold-off.
Written by David Emami