Conventional Wisdom: A Test for the Market and For John Kerry

This week’s national convention of the Democratic Party was a test for nominee John Kerry. It was a test for the stock market, too, with all the major indexes probing their lows for the year. It’s no coincidence that these two tests occurred in the same week.

The market passed the test. It was close, but the S&P 500 didn’t make intraday lows that were lower than it established last May. The NASDAQ made slightly new lows, but as of Thursday it has recovered from them, so I’ll look the other way. In a moment I’ll talk about whether Kerry passed the test as well as the markets did.

Democratic convention week was a test for the market because the event was seen as a potential target for a terrorist attack. The completely unpredictable nature of a potential attack — if it will happen at all, how destructive it will be, and how authorities and the public might react to it — makes it a particularly difficult risk for markets to account for. That’s a major reason why markets have been choppy over the last couple of weeks as the bottom of the year’s trading range has been tested.

It can get really crazy. On Monday, markets were roiled by reports that two parachutists had dropped into Boston near the convention, and had been taken into custody by the Department of Homeland Security. Over the next couple of days various forms of denials and “no comment” statements from officials only added to the weirdness.

It turned out that there were never any parachutists, of course. A Homeland Security officer had mistakenly identified a tent-flap that was blowing in the breeze. And the two men in custody were just common drunkards.

Now the convention is over, and we all feel silly for ever letting ourselves imagine that al Qaeda ninjas were descending on Boston. But can anyone who first saw the story flash across the newswires deny that he felt at least a brief surge of fear? If you are an investor — be honest — didn’t you consider selling some stocks when you heard the news? Maybe you actually sold them.

Well, that’s how markets work. In times of fear and uncertainty, those who lose control of their emotions and get carried away with fear — or who perhaps just rationally decide that they can’t take the risk — dump their shares. Who buys them? Brave people who can stomach the risk and are willing to do so provided they can get compensated for it by picking up stocks at panic prices.

That’s what makes bottoms: It’s the transfer of risk from weak hands to strong hands. And what makes rallies is when the weak realize the mistake they made, and find themselves having to pay up to get their stocks back from the strong. It has always been this way, and it always will.

It’s impressive to me that the market didn’t have to make new lower lows in order to accomplish this transfer of risk. For me, that’s testimony to the underlying strength of the economy, and the real value that’s getting baked into stocks as earnings continue to soar.

So the market passed the test of the convention. Did John Kerry?

Before I answer, let me say that when the Republican convention rolls around, I’ll ask the same question about George Bush — and I’ll be just as hard on Bush as I’m going to be about Kerry right now.

From the standpoint of an investor, I’m interested in whether a presidential candidate puts forth policy that will lead to higher economic growth. Investors needn’t be concerned about the many other aspects of a candidate’s agenda, those may be very important in ultimately deciding for whom you’re going to vote.

In these terms, Kerry failed the test. The convention was his opportunity to do more than criticize President Bush — to make voting for John Kerry an end in itself. This was his chance to overcome the attitude reflected universally in polling data that those who are likely to vote for Kerry don’t really like him very much — but they like Bush even less. Kerry couldn’t pull it off.

In terms of the economic agenda that we heard about from the convention podium, there wasn’t much beyond exaggerations of what’s wrong with the economy today. To hear the Democrats tell it, you’d think we were living in the time of Charles Dickens’ London, where “the poor” are exploited by “the rich” in prisons and workhouses. This likely won’t resonate with voters, because things just aren’t that way. The unemployment rate is about average, inflation is low, and both household wealth and home ownership are at all-time highs.

The Democrats also hammered on the federal budget deficits that have grown during Bush’s presidency. According to them, America is on the verge of becoming a bankrupt third-world banana republic. But this isn’t true either. Already, this year’s federal deficit is coming in $100 billion less than expected. And besides, the Democrats’ plan to fix it is to raise taxes — but then they say they are going to turn around and spend every penny of the tax increase on government-sponsored health insurance and other programs. It just doesn’t add up.

To the extent that Kerry failed his test of getting voters to like him instead of just hating Bush, then Kerry helped the market pass its test this week. As readers of this column know, all year I’ve been arguing that the stock market would prefer to see Bush re-elected, so that Bush’s pro-growth tax cuts can stay in place. So when Kerry seems like less of a threat to Bush, he’s less of a threat to the market, too.

Indeed, ahead of the convention, the futures contracts on Bush’s re-election probabilities, traded online at Tradesports.com, dropped to new lows — dipping for the first time ever below 50%. Now that the convention is over, they’re back above 50%. It’s still basically a coin-flip right now, but the coin is slightly weighted in Bush’s favor.

For the stock market, it’s all good. But there are more tests coming up. The summer Olympics and the Republican convention are both terror targets, so we can look forward to scary rumors and nervous markets — and hopefully, we can look forward to nice rallies when it turns out that nothing bad really happened. And when the Republicans hold their gathering in New York, Bush will be challenged to articulate his own economic agenda and overcome the intense dislike and mistrust of him that so many voters have.

Having passed this week’s test, I continue to believe what I predicted here last week: that markets will manage to work their way up, albeit painfully, through the year’s trading range. “Painfully” is the operative word, with so many risks out there. It’s not going to be a summer vacation for investors.

The above is an “Ahead of the Curve” column published July 30, 2004 on SmartMoney.com, where Luskin is a Contributing Editor.