Cameron Newland | Massachusetts Voters’ Complicated Effects On The Market

Massachusetts Voters’ Complicated Effects On The Market

After the Democrats effectively lost their filibuster-proof majority (and consequently any hope they might’ve had for passing their healthcare package), the US markets took a dive, with Bespoke Investment Group reporting:

The major indices are approaching the -2% level on the day, which would be the worst day for the market in some time. While some people thought a Scott Brown win would be good for the market, it appears to be doing the opposite. The dollar is strong today on the Brown win, which is hitting stocks (especially commodity-related stocks) hard. As shown below, the Materials sector is down 2.39% on the day. The Health Care sector is down the least of the ten major sectors at -0.96%. So while the Health Care sector has benefitted for the time being, the rest of the market is taking it on the chin.

To sum up today’s action, the markets responded in the opposite way that was expected by many market watchers and commentators, due in no small part to the complexity of global markets and the strong influence of currency fluctuations on US stock market indices. The first-order expected outcome of a Republican win in Massachusetts was that Congress would become less partisan and hence more inactive, which would be a positive sign for the market because legislative inaction means predictability for businesses and individuals, who can invest without fear of the unknown and potentially risky effects of legislative change. Instead, the financial markets reacted not to the perceived enhanced predictability of Congress, but rather to the projected effect on the country’s budget offered by the failure of the Democrat-sponsored healthcare reform bill. If the Democrats had been successful in passing their bill before the special Senate election, any such bill would’ve increased government spending, added to the deficit/national debt, and would’ve struck a blow to the government’s fiscal health, which is already in shambles. After this fear was vanquished by Massachusetts voters, the US Dollar rallied against major currencies, which consequently made US stocks more expensive to foreign investors and sent domestic indices sharply lower.

If any four lessons are to be learned from these developments, I think the following are constitute a good list:

1) Markets and their behavior are complex.

2) In order to accurately forecast the direction of the market given a certain event, one must consider more than the first-order expected outcomes, instead integrating the first-order outcomes with second and third-level outcomes in order to come up with a holistic meta/macro-outcome that integrates all necessary and relevant data and accurately predicts the macro outcome that follows from the behavior of the relevant market participants. In addition to integrating first-, second-, and third-order outcomes, one must have a strong understanding of reflexivity (in the sense that George Soros uses the word) to model the reflexive effects of a development upon itself and consequently the ‘integral system’, as I choose to call it.

3) Markets behave like biological systems and are composed of many actors, all with different incentives and behaviors. To accurately forecast the outcome of a given event, one must accurately model the micro-level decisions and behavior of particular groups of market participants, and model the groups’ behavior proportionately to one another when extrapolating the model into a full-size model simulated economy.

and 4) Even if your model is up to snuff with modern economic theory, your model may still spit out predicted outcomes that are completely wrong, so don’t be cocksure about your predictions—be humble.