How Should an Investor Follow Political News?

Important new policy initiatives are in the news every day. Politics is often a story on the business pages and is relevant for investors. Some of the Obama initiatives are already in place, but there are many issues still in play.

The Bespoke Investment Group, one of our featured sources, has highlighted the possibility that the GOP will take control of the House in the off-year elections. They cite Intrade.com which maintains a prediction market on an interesting array of issues. The Bespoke team noted that the GOP is now a slight favorite in the market. Here is today's chart (click to enlarge):

Background

How should the investor follow political news? Here are a few suggestions.

Do not allow your political opinions to interfere with sound investment decisions. Join me in being politically agnostic -- willing to make money no matter who is in power. Remember that the stock market has done very well (or poorly) with various combinations of partisan control . This is the most important rule.

View election news as a backdrop. A change in partisan control of the House or the Senate is relevant, but not determinative. It will dictate the nature of future compromises.

Analysis of specific legislation is most important. This is done rather casually by most. We cover the link between politics and stocks at our sister site, Election Stocks. The site is a great source of both continuing and emerging themes in policy decisions, with a specific emphasis on investment effects.

Focus on the House

Today I want to focus on the prospects for a change in control of the House of Representatives. The GOP needs a pickup of 40 seats to take control. There is often a rebound by the party out of power during the off-year elections, those with no Presidential coattails. The basic concept is that Presidential voting brings out party loyalists who vote a straight ticket. This does not mean that all are loyalists, only that it has a marginal effect.

One of the reasons that prediction markets work so well is that the investors in those markets do research and collect information. The watcher of the market gets the benefit of their research without doing any work.

As a former Political Science/Public Policy prof I like to do my own analysis. Here are some of the sources I watch.

• Larry J. Sabato's Crystal Ball. This is a bottom-up analysis that forecasts a GOP gain of 27. This approach has been very accurate in past elections. The forecast has not been updated for nearly two months.
• Prof. Alan Abramowitz of Emory has had the most accurate model in recent years. He sees a GOP gain of 37 seats, but has a "structural minimum" of 20, based on factors already in place.
• Prof. Alfred G. Cuzan, Poli Sci Chair at the University of Western Florida, has a nice model forecasting Presidential approval ratings from various factors. His conclusion is that the Obama ratings will continue to decline throughout the year -- and this is assuming unemployment falling to 7.7%! The significance of this work is that Presidential approval is an important input in the Abramowitz model.
• The 538 does a nice review of the academic literature, emphasizing that the Democratic downside might be greater than expected, and adding more statistical work.

Here is the key chart from the Cuzan analysis, forecasting the Obama approval ratings (click to enlarge).

Conclusion

It is easy to see why the prediction markets are swinging GOP. If the Democrats want to maintain House control, they had better hope for a dramatic improvement in the economy and the President's approval ratings.

GOP control does not mean repeal of the Obama agenda, but it would certainly force more compromise on key upcoming issues. Many observers see this change as generally bullish for the market. I see it as more relevant on an issue-by-issue basis.