- 2000: Volume 9, No. 6 Political Realities of the Markets

The Iowa Electronic Market (IEM) is a real-money futures market, in which contract payoffs depend on the outcome of economic and political events.

The IEM is operated by the University of Iowa for educational and research purposes. The business school's goal is to prepare their students to be intelligent market participants, by learning first-hand about the markets. The IEM provides a rich source of data for research, which the school integrates into their business courses.

The most active markets are the Presidential Winner Take All, and the Presidential Vote Share markets, as well as the Control of Congress market (see Table 1). Current quotes, historical price data and charts are available on the IEM Web site at www.biz.uiowa.edu/iem. As of October 4, for example, traders think Gore will receive 51 percent of the vote on election day, with Bush getting 48 percent, and other candidates taking down the rest.

Table 1

Control of Congress Market
Date	RH_RS	NH_RS	NH_NS	RH_NS
9/21 9/22 9/23 9/24 9/25 9/26 9/27 9/28 9/29 9/30 10/1 10/2 10/3 10/4	38.9% 40.4% 40.5% 40.4% 41.3% 41.0% 41.3% 41.6% 41.5% 38.4% 38.6% 38.4% 36.9% 36.0%	50.2% 49.1% 49.1% 49.1% 49.2% 48.4% 48.4% 47.8% 47.2% 49.1% 50.0% 50.1% 50.6% 50.6%	9.4% 9.3% 9.9% 9.9% 9.9% 9.6% 10.2% 9.6% 9.6% 10.0% N/A 10.2% 11.5% 11.0%	1.4% 1.3% 1.0% 1.0% 1.0% 1.2% 1.3% 1.3% 1.2%* 2.1% N/A 1.8% 1.1% 1.1%
As of October 4, 36% of traders think Republicans will hold their majority in the House and in the Senate (RH_RS). 50.6% are betting Republicans will lose control in the House, but hold on in the Senate (NH_RS). And 11.0% think Republicans will lose their majority in both parts of Congress (NH_NS). These four markets trade separately and these prices are the last trade of the day, so the sum may not equal 100%.

Anyone with a computer and money to risk can sign up and trade these political markets. Hence, the price data is a by-product of a diverse, nation-wide and (hopefully) knowledgeable population of traders. (No one wants to throw their money away, so these traders must have a clue.) Currently, there are 6,000 active accounts trading on the IEM.

The IEM is under the regulatory purview of the Commodity Futures Trading Commission. The small number of players, the research aspects of the Web site and the low investment amounts ($5 minimum to $500 maximum) have allowed the IEM to receive a "no-action" letter from the CFTC, exempting the IEM from regulation.

Who will be the next President and how will the surplus be used? That question is of great importance to the bond market. In 1996 we learned polls, which had Clinton ahead 15 to 22 percent, can be very wrong. (Clinton won by eight percent.) And unlike polls, which are taken two or three times per week, these political markets trade 24/7, so real-time quotes are always available for evaluation and analysis.

The Presidential Race: Watching the Dow

It is interesting to compare the Dow with Al Gore's vote share, which is trading on the Iowa Electronic Market (see Figure 1). A quick glance confirms the old adage that people vote with their pocketbook. And given the fact that more people now own stocks, that pocket book of wealth is well represented by the stock market.

Figure 1:

The Dow & The U.S. House

In May, we discovered that, when the Dow Jones Industrial Average rallied more than 10 percent in a presidential election year, it usually helped the presidential candidate of the party in power. A sell-off of more than 10 percent cost him in the November election (see Table 2).

Table 2

The Dow and the Presidency
Year	Dow's Change	Party In White House	That Party's Candidate	Candidate's Fate
1904 1908 1912 1920 1928 1932 1936 1960 1964 1972 1976 1980 1988 1996	+ 28.3% + 41.1% + 10.7% - 20.3% + 28.3% - 20.5% + 22.6% - 14.6% + 14.8% + 10.6% + 13.3% + 11.7% + 10.8% + 18.1%	Republican Republican Republican Democrat Republican Republican Democrat Republican Democrat Republican Republican Democrat Republican Democrat	Theodore Roosevelt William Taft William Taft James Cox Herbert Hoover Herbert Hoover Franklin Roosevelt Richard Nixon Lyndon Johnson Richard Nixon Gerald Ford James Carter George Bush William Clinton	Won Won Lost Lost Won Lost Won Lost Won Won Lost Lost Won Won

Question

The financial health of a country affects the level of contentment of its citizenry. When paychecks are fat and savings are rising, the people will be happy. In turn, they'll be satisfied with their leaders and vote to keep them in power. When pocketbooks are thin or people are losing their jobs, the electorate will blame their government representatives and vote them out.

The Dow is a barometer of the financial health of a country. We wondered, have large rallies or sell-offs in election years correlated with the fortunes of the party in power in the House of Representatives?

Approach

First, we identified the percentage change of the Dow from January 1 through election day, for each House of Representatives election since 1900. All the members of the House are elected every two years, so we calculated the Dow's percentage change from January 1 through election day for those 50 years.

Second, we defined a large rally/ sell-off as more than 10 percent advance/decline from Jan 1 to election day.

Third, when a large rally occurred, we identified how often the party in power gained seats in the House, or when a large sell-off occurred, how often the party in power lost seats.

Results

There were 50 House elections during the last century. A large election year rally or sell-off occurred 28 of those years.

In 17 (61 percent) of those 28 years either the stock market rallied and the party in power gained seats, or the Dow sold-off and the party in power lost seats. E.g., at the start of 1918 the Republicans controlled the House of Representatives and had 216 seats. From January 1 to election day, the Dow rallied 15.3 percent. Times were good, so in the election of 1918 the voters gave the Republicans 237 seats in the House. Going into the 1966 election, Democrats were in the majority with 295 House seats. From January 1 to election day 1966, the Dow fell 16.7 percent. The people were unhappy, so the party in power-the Democrats-lost 47 seats in the House election. (These 17 cases are bold on the table.)

During 11 (39 percent) of those 28 years either the Dow rallied and the party in power lost seats or the Dow sold-off and the party in power gained seats.

Table 3

The Dow and the House
Year	Dow's Change	Majority's Seats Before	Seats After	Gain/Loss
1904 1908 1910 1912 1918 1920 1922 1928 1930 1932 1936 1938 1950 1954 1958 1960 1962 1964 1966 1972 1974 1976 1980 1982 1986 1988 1996 1998	+ 28.3% + 41.1% - 14.4% + 10.7% + 15.3% - 20.3% + 21.8% + 28.3% - 25.4% - 20.5% + 22.6% + 25.6% + 11% + 26% + 25.1% - 14.6% - 16.5% + 14.8% - 16.7% + 10.6% - 22.8% + 13.3% + 11.7% + 14.9% + 22.5% + 10.8% + 18.1% + 10.1%	207 R 222 R 219 R 228 D 216 R 237 R 300 R 237 R 267 R 218 R 322 D 333 D 263 D 221 R 234 D 283 D 262 D 258 D 295 D 255 D 242 D 291 D 277 D 242 D 253 D 258 D 230 R 227 R	250 R 219 R 162 R 290 D 237 R 300 R 225 R 267 R 218 R 117 R 333 D 262 D 234 D 203 R 283 D 262 D 258 D 295 D 248 D 242 D 291 D 292 D 242 D 269 D 258 D 260 D 227 R 222 R	Gain Loss Loss Gain Gain Gain Loss Gain Loss Loss Gain Loss Loss Loss Gain Loss Loss Gain Loss Loss Gain Gain Loss Gain Gain Gain Loss Loss

Comments

Most agree the stock market reflects public sentiment concerning the financial health of the country. Personally, I think it is broader than that. The Dow moves with the sentiment of the people, regardless of the reason for their mood. Let's say the country was engaged in a war overseas. Defense spending would insure most had jobs. However, stock prices would struggle, because the people would feel uncertain and reluctant to hold anything but cash.

The political fortunes of the President are affected by the Dow, but why are the Representatives in the House affected too? Article I Section 7 of the U.S. Constitution may have something to do with it: "All bills for raising revenue [taxes] shall originate in the House of Representatives."

Additionally, the framers of the Constitution designed the House so its members would be the most accountable to the sentiment of the people. House members represent fewer people and a smaller geo-graphic area relative to Senators and the President. Representatives are also held to the fire most often-they are up for election every two years.

This data indicates there is a relationship between public sentiment (as measured by the Dow) and the political viability of the leadership of the U.S. House of Representatives. This provides some evidence that the goal of the framers to make the House most accountable to the people may have been achieved.

Alex Saitta is a vice president and Yuxin Li is a research assistant in the New York office of Salomon Smith Barney. Alex can be reached at alex.saitta@ssmb.com