Profiting from Politics

Keeping an eye on Washington can mean money in your pockets.

Surprisingly few understand the intimate links between investment profits and political decisions. Not that profiting is hard to grasp. But politics is. All but the most sophisticated investors are unlikely to see the extent to which most investment decisions incorporate political judgments—or are subject to being subverted by political decisions of one sort or another.

No question about it, by gaining a better understanding of politics, investors can improve their investment performance. But they can do more than that. Investors can turn the intricacies of politics to their advantage as part of a new approach to the fundamentals of investment. What I have in mind is a rational and systematic approach that can enable investors to recognize opportunities and avoid investment hazards—before they are generally understood by the marginal player in the market. In short, investors can profit from politics.

This can be done without actually becoming a politician. No need to turn into a cigar-chewing rascal of the sort who grows rich, Boss Tweed style, on inflated paving contracts. One merely needs to notice who is gaining or losing political windfalls—and take the indicated action in stock and commodity markets.

In an ideal, textbook world of free-market investment transactions, political insight and inside political information would be of little value, because politics would be at a minimum. The economy would be stable. That means stable money. One could look forward, for years and even decades, with confidence that the unit of exchange and the interest rate would not fluctuate wildly. Mad dictators throughout the globe, not to mention not-so-mad presidents and kings, could not put major banks into receivership simply by refusing to pay their countries' bank debts. In a better world, wars and schemes of governments would not choke off the free movement of goods, creating artificial shortages in some markets and surpluses in others.

Alas, there is a difference between what ought to be and what is. That difference is so great that no sane investor can expect to profit by overlooking it. But just how much information about political interventions is sufficient? And how can investors systematically and rationally get that information and process it?

Most investors probably have never consciously thought about the link between investment opportunities and politics. Nonetheless, investors who are successful, on a basis other than chance alone, must operate on at least some minimal political insights.

Most investors, for example, have learned that interest rates matter. They have also learned that Federal Reserve actions have some effect or other on interest rates. If interest rates go up, they may sell their stocks—a simple political insight.

Another simple political insight was put to profitable use during the last decade. Many investors bet that fiat money would depreciate faster than gold. That bet incorporated a great many assumptions about how the political system would operate and how markets would respond. It was by no means an exclusive insight. Anyone who had read any of the classical economists, even one so "perverse" as Karl Marx, would have been well warned that inflating paper money will soon cause it to decline in value relative to gold.

Investment in gold followed what I call a "library insight." An investor could have mastered it just as well by reading the classics as by intimately following current events. Indeed, what one could learn in the library might have been more important than keeping abreast of current events. And it was also rewarding, at least in some circumstances. Gold was a great buy at $35 per ounce, or subsequently at $650—but not at $800.

That seems to me to be a crucial point. Wherever books are kept, one can read about general truths and even general falsehoods. But what one finds is liable to bear the same relation to making money now as a stopped clock has to telling time: it may be true on occasion, but one still needs additional information to determine on which occasion.

Like the stopped clock, the insight upon which gold was a profitable hedge against political developments could not be followed at all times. And, by the way, that much could have been surmised in the library. But many of the people who bought gold were busy, probably too busy to read through the other thoughts of the classical economists. And they stopped short of gaining a sophisticated understanding of the business cycle, much less of the political developments that obliged the authorities to curtail monetary growth.

Most gold investors who were trading on this sort of simple political insight probably did so because of the power of example. They saw their friends making money early on, and those friends then became the advisors of later investors. It was like the stock market in the 1950s. People just bought to hold—a simple call, which for a long time was right. Buyers could have come in at practically any hour of any day for years and still have made money buying gold until about 1980.

It is interesting that investment newsletters proliferated during the '70s, the very period when clinging to one simple political insight was profitable. This implies several things about information and the market.

For one thing, the fact that a simple insight into political economy was for a decade a highly profitable one conferred an appearance of wisdom on those who advertised it. In some cases, this was deserved. But in many more, it was not. Complete ignoramuses, as well as a few crooks, were able to enthrall a following by propagating any lunacy they pleased, so long as it included the magic words "Buy gold." Obviously irrational claims found a level of acceptance that tells us a lot about the way many investors process information. They don't do it very well.

This points to an excellent potential for profit, which more savvy investors can take advantage of if they are able to get sound information and process it in a rational way. As the gold example shows, it may take years for the market to completely assimilate a major political discontinuity. Years. The advent of pure fiat money on an international scale was a terrifically confusing development that even the brightest people were slow to understand. And the market responded in a way I have come to believe is typical. It produced a "cartoon effect."

I have taken the name for this pervasive phenomenon from something every child has noticed on Saturday morning between Cookie Krisps commercials. It happens every time the cartoon animal walks unawares off the cliff. He just hangs there, rather than obeying Sir Isaac's laws. Eventually, he realizes what's what and gets around to falling. Participants in markets behave in a similar fashion.

There is an economic theory, called the efficient-market hypothesis, which supposes that the price of the moment already incorporates every datum known to anybody; no "false" prices exist as a result of poor information or poor computational abilities. I believe this is wrong. Though markets do tend toward efficiency, this is only a tendency. It is not magic. Wherever circumstances arise in which knowledge varies radically from person to person, and many participants will determine the outcome (price), those with the best information about the fundamentals will have more than a random chance of getting the price movement right.

A study by the Hulbert Financial Digest has shown that the prices of stocks seem to respond sluggishly to newsletter recommendations. A single recommendation often left a stock in a position to gain by further notice. As whatever information made the stock attractive was disseminated, that stock could be recommended again and still outperform the market. Indeed, stocks recommended by three newsletters tended to outperform those recommended by two. Only when four newsletters had jumped on the bandwagon was the advantage noticed in the original buy analysis completely discounted, with performance falling. Stocks recommended by five newsletters performed decidedly worse, usually faring more poorly than shares in the same group that had never been recommended at all. That should greatly encourage those who would try to profit from inside political information, since it demonstrates how slowly the market often reacts to shared insights.

Points of discontinuity, where there are abrupt breaks in trend, offer the greatest chances for profit. These discontinuities account for dramatic price movements. And the fact that discontinuities are not anticipated—and thus discounted in advance—is really additional evidence against the efficient-market hypothesis. Many of the changes that affect prices are foreseeable—as indeed the rise of the price of gold was foreseeable. But they are seen at first only by a few people, sometimes because those people are the only ones in a position to know.

Of course, there are all kinds of discontinuities, but political actions must rank with acts of nature as the largest influences affecting markets. Nothing else comes close. That is not to say that changes of taste cannot be abrupt. When Clark Gable bared his chest in It Happened One Night, undershirt sales in the United States fell by 50 percent within the year. And the computer industry clearly illustrates that changes in technology can sometimes arise with startling swiftness. Even where such changes are gradual, as they usually are, markets may react suddenly.

In contrast to changes in taste, political decisions are characteristically abrupt—precisely because they involve "interventions" to halt or sidetrack the outcome that would be generated by market forces working alone. Decisions made by bureaucracies or executive fiat need not be gradual. They can be completely arbitrary—like fire, floods, and bad weather.

Unlike acts of God, however, acts of politicians have comprehensible motives, making them easier to understand—and predict. If the market for such information were more highly developed, a great many events that now take investors by surprise would be more readily understood. To a degree, this development is already under way, as political risks have increased relative to natural hazards as influential factors in international investment and trade.

Insurance companies are today hiring political-risk analysts to calculate the probability that, for example, the banana plantation will be expropriated. Through much study, along with trial and error, political-risk analysts are becoming increasingly knowledgeable about the factors contributing to abrupt political changes.

The same type of information hunt has been intensifying at the domestic level for the past 15 years. As more sweeping and detailed interventions have come out of Washington, sophisticated business people have been obliged to learn what is going on in far greater detail than one can get in the mass media. Newsletters reporting on individual bureaucracies now constitute a substantial industry in Washington. But the use of such newsletters has been almost exclusively confined to company management, lawyers, bureaucrats, and a few very rich investment specialists.

For $575 a year, one can read McGraw-Hill's Inside FERC. For $535, one can get Inside EPA from Inside Washington Publishers, Inc. Other equally expensive and highly detailed newsletters discuss, among other things, "Section 223(f)" housing projects and the Community Development Small Cities Program, securities regulation, federal contracts, and Federal Communications Commission (FCC) rulings. And for the bargain price of just $325, there is even the Noise Regulation Reporter.

Together, these publications and hundreds like them are brimming with detail about political interventions. If one read them all, one would know more about what government is doing to alter the economy than any other person, including government officials themselves. And these decisions are not trivial. Barely a bureaucracy in Washington does not have the power to bankrupt someone—or make someone else a fortune, if he merely fills out the proper forms in triplicate. The decisions made in any given week will cause billions to change hands. Billions!

Clearly, information about who will gain or lose billions is of great potential value to investors. If the lead-additive industry is likely to be wiped out by an impending EPA regulation, this will not only interest environmentalists and company management. It will also be reflected in the stock market and probably the commodity market. Those who got early warning could sell short and pocket a handsome profit.

What continues to astonish me is that newsletters oriented toward investors make almost no use of this kind of detailed, inside information. From the point of view of someone trying to make money, political discontinuities are an untapped gold mine. Yet they are allowed to lie there, like a vast, unexplored vein of ore, while most newsletter editors and readers sift the same familiar ground over and over.

I mention newsletters because they are the main source from which this inside political information could be obtained. It certainly would not be available from the mass media. Most Americans—indeed, most investors—don't even know what FERC (the Federal Energy Regulatory Commission) is, let alone what it does. Yet its decisions about energy regulation can have far-reaching capitalization effects. Only where the largest companies and great controversies are involved will any of this join the reports from Lebanon and shots of Gary Hart's photogenic face on the nightly news.

Of the thousands of financial newsletters, only a few place enough regular emphasis on political coverage to even feature it in their advertising. Of course, almost all drift into discussion of political discontinuities—with predictions about what the Federal Reserve will do or how a planned defense build-up will be good for Lockheed. Beyond that sort of occasional mention, only a handful of publications make political coverage a major feature of analysis. And among that handful, the analysis of politics tends to be superficial, conspiratorial in tone, and even laughable in its lack of sophistication and overt political prejudices.

So when I talk about political information that could be useful to investors, I'm not talking about the sort of financial newsletter that would feature a headline story such as this: "One of the Satanic Signs of the New Age Movement Exists Right on the Dollar Bill." I'm not talking about explanations of what the news reported in various newspapers "really means"—namely, that Bilderbergers, the Trilateral Commission, "Insiders," etc., are doing the world dirty. From such newsletters, for example, we get the following kind of analysis in the wake of the Kissinger Commission's policy recommendations regarding Central America:

Just as the Trilateralists organized the fall of Iran during the Carter Administration, the Reagan years will mark the fall of El Salvador.…Evidence continues to mount that Mexico is to be used as an armed camp for training peasants to fight a terrorist war in the Southern United States.

The punch line for the investor is that property along the border will be threatened. Presumably, this implies lower land prices from San Diego to Brownsville.

Such may be enjoyable for anyone who believes that Satanic conspiracies hold the key to micro-political events. But this kind of "political information" will not be of much use to investors.

Nor are they likely to benefit from a variation on the standard conspiracy theory, which identifies firms owned or controlled by leading financiers thought to be part of the international banking elite. This is to enable readers to cash in on the schemes by buying shares of the "Insider" (always with a capital "I") companies. The reason I doubt this sort of approach can be very useful is that every major firm is in some sense an elite enterprise. Without careful analysis of political maneuvering that is actually taking place, the investor has no way to choose among them.

But when I talk about useful political information, I'm not talking either about analyses claiming to utilize secret reports from the world's intelligence services, filtered through retired agents. Reliance on so-called secret reports has several shortcomings. Much information culled from intelligence reports is already public; one could just as readily obtain the information from the Wall Street Journal. But even if the information is still secret, how is the reader to know that it is accurate or that its interpretation is correct? And if others don't already know it and it's accurate, what are its implications for investment opportunities?

No, what would really be useful to investors, and what the run-of-the-mill financial newsletter doesn't provide even when it claims to offer political coverage, is analysis of investment possibilities from a strictly political perspective, with an economic rather than a conspiratorial view of politics. I'm talking about micro-political reports of exactly the sort found in the specialized "inside Washington" newsletters—with the difference that the reader of such a financial newsletter would also be provided with the names of companies that will benefit or be harmed by pending government interventions or political upheavals. The resulting investment intelligence should be quite as useful to a member of the Trilateral Commission as to a member of the Birch Society.

Thus, when the Kissinger Commission issued its recommendations, one would not be led to suspect guerrilla war in South Texas but rather to anticipate that Central American arms purchases were likely to rise. Checks with Defense experts and Central American sources would produce some fairly clear conclusions about what type of expenditures would be made and which firms stood to gain. And the names of these firms would be reported.

To give another example, one would find in such a newsletter a detailed analysis of a proposed change in FCC policy by which Zenith Radio Corporation would stand to gain greatly. If the Federal Communications Commission were to issue a technology standard for stereo TV that required that Zenith designs be employed by everyone in the US market and were to mandate use of noise reduction systems made by the British firm DBX, the names of all the companies (in this case, 17) that seem likely to gain or lose from some consequences of the ruling would be spelled out.

To use such political information to best advantage, an investor should chart the price movements of the firms and commodities likely to be affected. If the price charts do not show substantial divergence from trend charts for the market as a whole, it is a fair guess that the information has not been discounted. An investment based on it would probably be a safe bet—if the likely capitalization effect could be significant enough to show up in the price.

A fully comprehensive political investment service would attempt to isolate "pure plays" from inside information. For example, the Environmental Protection Agency recently prepared a cost-benefit study suggesting that leaded gasoline should be banned immediately rather than phased out over the rest of this decade. This implies trouble for firms that produce lead (70 percent of which is consumed in auto use) and those converting lead into additive form. Basically, only three companies do that—Ethyl, Nalco Chemical, and Du Pont. To follow through on the most comprehensive and rational basis, one would want to know not only how the shares of these companies had been behaving over the recent past in comparison to the market as a whole (to see whether the information had been discounted). One would also need to see how heavily capitalized each company was and what percentage of its business was derived from sales of lead additive.

Undoubtedly, Du Pont is not going to go broke because of a ban on leaded gasoline. But what about Ethyl or Nalco Chemical? A close look at their business mix would show which of the two firms (if either) would be a candidate for a short sale. One would also want to run the same numbers on Misacro, a lead producer, and Philbro-Salamon, parent of St. Joseph's Lead.

Almost all of these inside tidbits could be isolated into one or more obvious plays in stock or commodity markets. If the evidence supports my thesis that political events do influence investment outcomes and that these outcomes can be reasonably predicted, this could mean a brand-new approach to investment—an approach based not on the fundamentals of the firm (in a direct sense) but on political fundamentals. For investors who are sophisticated and rational enough to pursue this approach, it may be possible to earn high profits by violating Bismarck's famous adage—"No people should know how their laws and sausages are made." Those with the stomach for it can do quite well by forgetting the sausages and concentrating on the laws.

James Dale Davidson is founder and chairman of the National Taxpayers Union and the author of The Squeeze. He also coedits with Sir William Rees-Mogg an investment advisory newsletter, the London-Washington Report.