How Will The Election Effect The Market?

<b>here is an interview I did with Donald Luskin on the Presidential election several years ago. He also talks about a unique trading method.

enjoy!!

surf </b>






Donald was Vice Chairman of Barclay’s Global Investors (formerly Wells Fargo Investment Advisors) one of the largest investment management firms in the world with over $500 billion under management. He was involved in the creation of the OEX index and was lead market maker in Chicago for OEX options at the contract's introduction.

He presently specializes in providing cutting-edge research to hedge funds and money management firms via his website, www.trendmacro.com. Donalds’s current interest and expertise lays in the application of his knowledge of macroeconomic forecasting to market strategy. How politics and governmental intervention affect the market is one of his primary areas of focus. He is a media provocateur and publishes the popular web blog, www.poorandstupid.com. On the eve of the presidential election, I can think of no one timelier to interview. Let’s get started!

DAVE: Let’s first get into a bit of your history, your evolution as a trader.

DONALD: My interest started with an interest in gambling. Back in the 1970’s, I learned the skill of card counting and started beating the casinos. This was back in the single deck blackjack days; one could actually do this without being thrown out of the casino. Many of the card counters then were market makers on the Pacific Stock Exchange, which I joined in 1979.

DAVE: This was before option models become commonplace?

DONALD: The Black Scholes model was still relatively new and personal computers were still novelties. If you had real-time access and computer models back then, you were the one-eyed man in the land of the blind. The models were imperfect, but they were enough to give one a significant advantage.

DAVE: I know you involved in the creation of the OEX options in Chicago. One of my first trades was in the OEX options, so I find this part of your history fascinating.

DONALD: Yeah, those were the days. When I was a market maker on the Chicago Board Options Exchange, my business was based around certain aspects of the tax law. Those laws changed in 1984 and pretty much put me out of business.

DAVE: What was your involvement in the early days of the POSIT ECN?

DONALD: It was my idea. And I wrote the business plan for Investment Technology Group, as a unit within Jefferies & Company. It's now a separate public company, and POSIT now does somewhere around 10-15% of NYSE volume everyday.

DAVE: Wow, I’ll say that was a success! Tell me a little about your open mutual fund MetaMarkets.com.

DONALD: MetaMarkets.com was a web site that offered a web-based mutual fund called OpenFund. It was the first interactive mutual fund. All the trades, all the positions, everything was done in real time on the Internet. The investors could talk to the portfolio manager and traders in real time. It was meant to be a fusion between online trading and mutual funds.

DAVE: That seems like a really cool idea. Is the fund still operating? What happened?

DONALD: Well, we launched MetaMarkets.com in the late 1990’s during the dot-com craze. Like the other dot-coms, we invested heavily in advertising when getting market share was the top priority -- always assuming you could get more venture funding when you ran out of money. But after the bubble burst, the money dried up. In addition, public interest in the stock market took a dramatic hit. We went from being massively in favor to massively out of favor. It doesn’t take long to get crushed when this happens.

DAVE: I know exactly what you mean. I was involved in the E*Trade Media launch. I worked on their radio programming. They spent tons of money, built a monster studio in NYC, then all of a sudden, poof, they were gone.

DONALD: Yeah, it can happen fast.

DAVE: Ok, Lets jump into how you view the financial markets. What is your primary method of analyzing the market?

DONALD: My firm, Trend Macrolytics, takes a top-down approach. We apply macroeconomic forecasting to market strategy.

DAVE: Please explain this a little deeper.

DONALD: We don’t recommend individual stocks. The deepest we get into the details is stock sectors. Our primary focus is broad asset classes. The only time we even think about individual stocks is to the extent they are symbolic of the macro economy, such as, say, Microsoft. Our analysis is based on forward-looking market-based indicators.

DAVE: What do you mean by forward- looking indicators? Is there a way our audience can apply these indicators to their own trading?

DONALD: Sure, I’ll give you some examples. Right now the key to the macroeconomic picture is inflation and deflation. My partner, David Gitlitz, was the first American economist to forecast deflation, back in the late 1990s. Respectable economists never even mentioned the word then. It was thought to be impossible. But David was right. And he didn't make that great call with the typical macro indicators like the CPI, which are backwards looking by definition. They are kind of a scorecard for what has happened in the past. They are not much good for forecasting inflation or deflation in the future. So, back to your question—we believe that commodities (such as gold) and foreign exchange rates are critical forward looking indicators of inflationary risks. These markets give forward-looking estimates of inflation that can be extrapolated to forecast how financial markets will move in response to changes in inflation

DAVE: Can you explain this concept in more detail?

 

DONALD: Ok, we view inflation/deflation as changes in the value of money. Most people view inflation/deflation as the general rise or fall of prices of goods. This is not the correct way to view these things. Inflation is the decline in the value of money, and deflation is the increase in the value of money, that is used to express prices. So, does the price of apples go up 10% or does the value of money used to purchase the apples go down 10%? We think the latter. The commodities we look at are things that have historically been substituted for money—things like gold, oil, and other countries' money. We believe specifically that by watching these forward-looking indicators you can accurately forecast the backwards-looking statistics like the CPI, thus mapping an investing strategy for inflation-sensitive securities like Treasuries. Simply, it’s looking out the windshield to see what the rear view mirror will be showing you in 5 minutes.

DAVE: In addition to the macro forecasts, I know you use some unusual technical analysis tools to make decisions. Please elaborate.

DONALD: We have a technical analyst named Fred Goodman. Fred is an expert in a very unique charting method called Price/Volume Charting.

DAVE: Did he invent this method? I have never heard of it. How do you use it?

DONALD: No, he did not invent it. He learned it from his mentor in the 1950’s, named Benjamin Crocker. I have never met anyone who knows Crocker's work other than Goodman. The way it works is you take an index like the Dow, but you can do it with individual stocks too, and you plot on a chart a point that represents the intersection of price on the vertical axis and volume on the horizontal axis.

DAVE: Let me see if I understand you so far. For example, one creates a chart with price, say 10-100 on the vertical axis and volume say, 1000-100,000 on the horizontal axis. For example, the price is 35 and volume is 25000 at a particular point in time, so you put a point on the chart where these intersect. Is this correct?

DONALD: Yes, that is the first step. After you plot a series of these price/time intersections, you connect the dots. Over time, the lines that connect the dots will form loops on the chart. If these loops go clockwise, it’s a buy signal. If the loops are counter clockwise it’s a sell signal. You can read all about it on our website at http://www.trendmacro.com/a/goodman/keyIndicators/pvCharting.asp.

DAVE: Wow, that is fascinating. In all my years of involvement in the market, this really seems like something new.

DONALD: Yes, it’s very unique. I have been following it over the years and have found that as a short-term indicator it’s pretty good. You need to keep in mind, however, that as with any technical indicator, it's tough to scientifically prove that it works, because interpretation plays a role.

DAVE: Is this method computerized or does Fred do it by hand?

DONALD: For many years, he has been doing the charting by hand. Actually what he’s just on the verge of unveiling right now is a numerical system for describing these loops, which until now has basically just been just visual. He’s now applying this en masse to hundreds of stocks at a time. He’s not really ready to reveal this to the public yet. That’s still a couple of months out, but the stuff he’s doing in the lab is very, very impressive.

DAVE: Moving on here, I know you study the impact of politics on the market. How do you think the presidential election will affect the stock market?

DONALD: The presidential election is the single most important issue in the stock market right now. You can prove this to yourself by looking at the Bush Contract on Tradesports.com. Look at those contracts this calendar year; there has been a very high correlation between the S&P 500 and those contracts. The contracts tend to lead the market by a couple of weeks, but as we are getting closer to the election, the lead-time is becoming shorter. I have written extensively about this and the idea has gotten out there. Like all good ideas, they eventually stop working.

DAVE: When the Bush contract goes up, what happens to the market?

DONALD: The market goes up. I interpret this to mean that the stock market prefers a Bush victory. It’s amazing when you compare the Bush contract to the S&P 500. You can see that all year the market has been up and down in proportion to George Bush.

DAVE: This seems like a tradable edge could develop here.

DONALD: Well, you certainly have the house edge if you are long stocks now. If Bush wins, they go up. If he loses, they've already gone down so there isn't much downside. However, there is still a tremendous amount of uncertainty around the election. Uncertainty is the worst thing for the stock market.

DAVE: Yes, I recall the elections in 2000. Even after the results were in, it was uncertain who won. The market dropped during this time.

DONALD. Exactly. There’s a tremendous amount of uncertainty right now in the election because it pretty much seems 50/50. You know if Bush gets re-elected, there’s a good chance that his tax cuts will be kept and that’s good for the market; and if Kerry gets in, he’ll try to get rid of them and that’s bad, but right now, there’s a tremendous uncertainty. Uncertainty builds a risk premium in the market. When that uncertainty is eventually removed, even if Kerry is elected, the mere fact that that uncertainty is removed is going to be good for the market.

DAVE: The best thing for the market would be a Bush victory?

DONALD: Now if the uncertainty is removed and Bush wins, that’s better. You’ll get the advantage of Bush winning, plus the risk premium goes down. And if the uncertainty is removed and Kerry wins that’s not as good. With Kerry, yeah you’ll take the loss of Kerry winning, but you’ll be cushioned because the risk premium will come out. So, you definitely have the house edge now to bet on the market, even if you’re not thinking about who wins the presidency. If you think Bush is going to win you should be buying stocks with both hands here.

DAVE: The worst thing for the market would be a repeat of 2000 where there was no clear winner?

DONALD: Yes, not having a clear winner would be very bad for the bulls.

 

DAVE: Do you think it is likely that the election will be contested?

DONALD: Well, I think it’s incredibly possible to happen again for a couple of reasons. One -- because of the experience in 2000, lawyers on both sides are totally poised to do it again, you know. That was an improvisation last time. The Democrats questioned the Florida election, but the Republicans could have questioned four other state elections where Gore won by similar margins. Republicans could have sued for recounts in those elections, but they didn’t. This time they certainly will. So it’s something that both sides will do whatever they can to win. Now there are three things at work this election year that are actually worse than they were in 2000.

DAVE: What are the three things?

DONALD: There are still some of those hanging chads out there!

DAVE: Ha, ha. You can’t be serious.

DONALD: You would be surprised! Number one---now we have touch screen voting computers, which do not produce a paper trail and supposedly they can be hacked. I don’t know whether any of that is true, but a day doesn’t go by that you don’t read some horror story about this. Number two--- a new federal regulation requires that a polling place allows you to vote if you simply show up and announce that you want to vote, even if you are not registered. This is called “provisional polling”

DAVE: Wow, I can see the potential for fraud there. When did this come into play?

DONALD: This is a new federal regulation as of about 18 months ago. Of course what that means is that you know there are all kinds of chances for mischief, where people just go from polling place to polling place and vote tons of times and hope that they don’t get caught and figuring, hey look, worse thing that can happen and they throw out all but one, and the best thing that can happen is that I get to vote for my guy ten times.

DAVE: Interesting. What’s the third thing that makes this election more likely to be contested than the 2000 election?

DONALD: We could have a tie. We now have one more electoral college vote in the United States than we did in 2000, so there’s not an even number. There was an odd number in 2000. So, under the Constitution, a tied electoral college vote goes to the House of Representatives. Put all this stuff together, and if we go into this election as we are today, fifty and a half/forty-nine and a half in favor of Bush, that’s close enough to where we probably won’t have election day, we’ll have election month.

DAVE: As traders we can pretty much count on uncertainty in the election at this point, are there any market plays you would suggest to capitalize on the uncertainty?

DONALD: Well, it’s tricky. What we’re telling our institutional clients is that there’s a house-edge type bet in favor of equities here.

DAVE: Okay.

DONALD: We see this house edge as very, very huge. This risk premium is very, very deep, and you know if you’re a long-term investor, this is a great time to buy stocks. Now, that’s very different than if you’re a trader. I have a paradox right now. Uncertainty is very high, but volatility is very low.

DAVE: Yes, the VIX is near all-time lows.

DONALD: Option premiums are quite low. Normally what you do in a period where you’re forecasting that nothing will go anywhere is you sell straddles. You’re not going to get a lot of money for selling straddles right now.

DAVE: Right.

DONALD: Buying straddles seems to be a good bet here, on the theory that something will come along and catalyze change. You know with these premiums, if you own a straddle and there’s a terrorist attack.

DAVE: Yeah.

DONALD: That’s kind of a good deal.

DAVE: Oh yeah.

DONALD: You know it’s ghoulish to position yourself for a terrorist attack, but it’s a fact that it may happen.

DAVE: Wrapping things up here, is there anything you would like to leave our audience with?

DONALD: I would just like to say that I think there is a tremendous opportunity now. I’ve built my business on it. Recognize that politics and the intervention of government in business affairs and in the economy is by far, the single most important thing to know as an investor. And if you can get that right, you can make every other mistake and you’ll be fine. I think the opportunity is there and that these things are what most investors dismiss as background noise. It’s quite the contrary; it’s foreground noise. There are very few people looking at it and most of those who do, look at it incorrectly. If you agree with me that politics is the most important thing, then this is your time, baby, because you know there has never been politics like there is today.

DAVE: Thank you for joining us today, Donald.

DONALD: Thank you for having me.