Times of Uncertainty — Investor Amnesia

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What a week, eh? I feel like everyone is beyond fed up with politics and elections after the week that we just had, so I’ll do my best to steer clear of the topic in today’s post. That said, however, I think that the twists and turns of the last seven days provide an excellent reason to dive deeper into how markets react in times of uncertainty. For example, I’m sure that few investors would have been so bold to suggest that the major US indices would all rip higher than 5% during the week of the election (NASDAQ (+8.91%), S&P 500 (6.67%, Russell 2000 (+6.41%). Yet, here we are.

While it appears that we now have some certainty over who the next President of our nation is in Joe Biden, there are still elevated levels of uncertainty around how we will move forward as a nation, and how the incumbent President will promote the peaceful transition of power. I know that I had included a bit on the 1876 Election and subsequent 1877 Compromise a few weeks ago, but I think it is worth posting again given the events of this week. If you think that this is a conteste election, imagine living through the 1876 election where “Republican Rutherford B. Hayes defeated Democrat Samuel Tilden by a single electoral vote after a dispute that wasn’t resolved until the eve of Hayes’s inauguration in March of 1877.”

The Compromise of 1877

The following description of this seminal moment in American history comes from New York Magazine:

“… if you want an example of a real nation-rending, Constitution-bending contested presidential election that might have conceivably led to a second Civil War, you have to go back to the U.S. Centennial Year of 1876, when Republican Rutherford B. Hayes defeated Democrat Samuel Tilden by a single electoral vote after a dispute that wasn’t resolved until the eve of Hayes’s inauguration in March of 1877.

The solid popular majority (including ex-slaves in the South protected by the actual or threatened presence of federal troops) that had reelected Civil War hero Ulysses S. Grant in 1872 had been weakened by a sustained economic depression, systemic corruption, and southern white resistance to (and northern white fatigue with) Reconstruction. The midterm elections of 1874 produced an epochal 94-seat swing in House seats (there were only 293 seats at the time) towards Democrats, who won the chamber, even as “redemption” movements aimed at restoring white political power (often behind ex-Confederate leaders) made big gains in the South.

By the time voters went to the polls to elect a successor to Grant, he had all but despaired of continuing Reconstruction, with federal courts undermining civil rights enforcement powers and Congress no longer interested in restoring them. Mississippi was “redeemed” for Democrats in 1875 amid widespread white terrorism, leaving just three southern states (Florida, Louisiana, and South Carolina) under Republican control, with another (North Carolina) closely contested.

When Ohio Governor Rutherford B. Hayes won the GOP nomination in 1876, he was mainly known as a hard-money champion and a mild supporter of civil service reform. Privately he had expressed a not-uncommon disinterest in using federal power to defend Black voting and other political rights, though Republicans did “wave the bloody shirt” by accusing his Democratic rival Samuel Tilden (a New Yorker mostly renowned for fighting Tammany Hall corruption) of being a puppet of ex-Confederates.

Much of the South was conceded to Tilden, though as Reconstruction historian Eric Foner has explained, in the four “unredeemed states,” local Republicans “waged a desperate struggle for survival” knowing that a restoration of Democratic control would lead to a restoration of white supremacy. Engagement was high everywhere in the country, as reflected in the 1876 election’s record-high voter turnout of 82 percent — a level which has never again been equaled.

With the economy being the main public preoccupation in the north, Tilden won the key swing states of Indiana, New Jersey, and his own New York, as well as a clear plurality of the national popular vote (at least as reported — widespread violent voter suppression in the South cast considerable doubt on Tilden’s margin). Late on Election Night, Tilden was one electoral vote short of a majority, with three of the “unredeemed” southern states (Florida, Louisiana, and South Carolina) plus Oregon still unresolved.

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Subsequently, legal battles broke out in the three southern states over both the presidential contest and partisan control of state governments, with competing slates of electors being sent to Washington by all three. In Oregon, where Hayes’s popular vote win was not disputed, the Democratic governor claimed one of the three Republican electors was legally unqualified, and appointed a Democratic replacement. At this point, rarely-consulted and not terribly clear constitutional provisions governing congressional certification of electoral votes came into play. Republicans claimed the President of the Senate (a member of their party) had the power to determine which slates of electors to accept, and Democrats claimed the full Congress had to concur, which might mean the House (which it controlled) would resolve the election if no electoral college majority was recognized.

As the time neared in January 1877 for this fateful decision to be made, tensions rose around the country and in Washington. Democrats were particularly motivated given their candidate’s apparent popular vote margin (ultimately judged to be three percent) and threatened “Tilden or War.” Southern Blacks feared that a Democratic administration might reinstate slavery. As Ohio Republican congressman James Monroe recalled in 1893, there was no obvious scenario for resolving the crisis:

‘It was repeatedly stated on the floor of the House of Representatives, and apparently believed by the majority, that if the Republican party should proceed, through the President of the Senate, to count the, votes of the disputed States, and declare them for General Hayes, the House would then proceed to elect Mr. Tilden, or to count the vote and declare him elected by the nation. There would then have been a dual presidency, a divided army and navy, a divided people, and probably civil war. What plan could be devised to save the country from the evils that threatened it?’

The Electoral Commission of 1877

Eventually, President Grant and other Republicans proposed a special bipartisan commission to deal with the situation created by the ambiguous constitutional language on counting and certifying electoral votes, and after some hesitation Democrats accepted it. The commission would be composed of five U.S. Representatives (three Democrats and two Republicans), five U.S. Senators (three Republicans and two Democrats), and five Justices of the U.S. Supreme Court (two appointed by Republican presidents, two by Democratic presidents, and one — assumed to be Justice David Davis — reputed to be independent. But a ploy by Democrats to curry favor with David backfired horribly, as history professor Ari Hoogenboom explains:

‘[Davis] disqualified himself after a monumental miscalculation by Tilden’s corrupt nephew, Colonel William T. Pelton, who assumed that electing Davis as senator from Illinois with Democratic votes would purchase his support for Tilden on the Electoral Commission. Davis was replaced by a Republican, Joseph P. Bradley, giving Hayes’s party an 8:7 edge. Bradley did have an independent streak, but in strict party votes Hayes was awarded the disputed states.’

The obvious partisanship of the commission vote and continuing sentiment among Democrats that Tilden had been robbed led to resistance, via a rare filibuster, in the Democratic-controlled House to a final certification of the electoral vote. This was the situation as the March 3 Inaugural Day approached. But in a series of very secret meetings in Washington, what was later known as the Compromise of 1877 was hammered out, as Nicholas E. Hollis later summarized:

‘After months of stalemate and rising tensions over the contested Election of 1876, emissaries from the Hayes-Tilden camps privately met several times at the Wormley Hotel and negotiated a settlement…arguably one of the most important in our Nation’s history which remains shrouded in denials to the present.  The “secret deal” was formulated only days before the end of the Grant Administration under threat of filibuster and violence on Monday evening, February 26, 1877, chiefly, in the rooms of W.M. Evarts (a key Hayes backer who served as counsel to the Electoral Commission and later became as Secretary of State in the Hayes Administration).

The Wormley Agreement paved the way for the end of the Reconstruction Era, providing assurances for the early withdrawal of remaining Federal troops in three southern states (Louisiana, South Carolina and Florida) and the right of these states to “control their own affairs.”  The written pledge provided by trusted Hayes’ aide (Charles Foster) to John Young Brown (D-KY) of the Tilden group cemented a strange alliance between Hayes’ Ohio Republicans and Tilden’s southern Democrats.’

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Soon thereafter the House filibuster ended, Hayes’s electoral vote victory was certified, and he was peacefully inaugurated.”

How the 1876 Election Tested the Constitution and Effectively Ended Reconstruction - HISTORY

Nuts, right? Well what about the stock market? How did it perform during this period of intense political uncertainty and divisiveness? Here’s what we can glean from the Global Financial Data database:

A popular adage is that “the market hates uncertainty”. Well, in the articles that follow below we are going to dive into that a little bit further to see how accurate a statement this is. The important point to remember is that through every one of these periods we have come out the other side, and are stronger for it.

Now let’s dive in!

The Bond Market and the Legitimacy of Vichy France

vichy france

Now obviously this is a much more extreme example of how markets react to the prospects of a new government regime, but this article is fascinating nonetheless. For those that need a brief refresher, see the description below:

After France’s military defeat in June 1940, the French government asked Marshall Henri Philippe Pétain, the French hero of World War I, to create a government that would negotiate an armistice with Germany. As a result, two zones were created: one under German occupation, the other in theory under French rule. A new capital city, Vichy, was designated for the latter. In practice Vichy’s collaborationist government remained dependent on Germany.”

However, this led to geopolitical issues around who should be viewed as the legitimate rulers of France:

Général Charles de Gaulle refused to accept German control and continued the war from Great Britain. By the end of 1940 de Gaulle had brought several French  colonies to his side. De Gaulle’s political legitimacy remained an issue during the war.

For Vichy’s government, he was a traitor, for the Allies, a military supporter. On September 24 1941, de Gaulle created the Comité National Français (CNF) in order to “have a structure that would bring him closer to the Allied governments in exile in London.” However the Allies considered the CNF as representing no more than the French troops fighting with the Allied ones. On September 28, 1942, the Soviet Union recognized and offered support to the CNF. Up to 1942, in spite of Vichy’s collaboration with Germany, Pétain was viewed as France’s legitimate ruler by the American government. Pétain lost this recognition when the German Army invaded the Vichy zone on November 11, 1942.

With such lack of clarity over who the legitimate governing body was in France, how did investors respond to this uncertainty?

‘During World War II, the spread between the 3% Rentes and the Vichy government bonds reflected French investors’ perception of the shifting fortunes of war and the willingness of future post-war government to repay the debt issued by the collaborationist regime. Structural breaks in this spread do not always match with the dates of major military events but are more closely related to the political ones, emphasizing the struggle for legitimacy by rival claimants to power.’

The Century of War: Bear Markets in the 1700s

Total War Center Forums

I think most of us would agree that it would be difficult to invest during a century colloquially known as “The Century of War”. This article from Global Financial Data looks at the bear markets that transpired amid the countless military conflicts in the 18th century.

There were five bear markets in the 1700s, in 1700-1701 (a decline of 36%), in 1704-1712 (a decline of 40%), 1719-1762 (a decline of 89%), 1768-1784 (a decline of 37%, and between 1792 and 1797 (a decline of 41%). There was also a bear market between 1688 and 1696 during which the market declined 46%. What caused each of these bear markets?”

Did Investors Expect an Institutional Breakdown? Stock and Bond Markets and Political Violence at the Onset of the Spanish Civil War

Spanish Civil War | Definition, Causes, Summary, & Facts | Britannica

Did Spanish investors expect a traumatic breakdown of the existing economic and institutional order in the run up to the outbreak of the Civil War? The paper explores this issue by looking at financial markets in the years that preceded the dramatic events of July 1936. Our purpose is empirically to assess the notion, advanced both by contemporary commentators and by historical narratives, that political developments were the main determinants of investors’ sentiment in the 1930s. We test for structural shifts in the mean and variance of stock and bond markets in coincidence with main political events, and assess their short-run impact by using an event study approach.

We also test the impact of political vs. macroeconomic “events” on markets’ behaviour. Comments from stock market chronicles are used in order to investigate the public’s perception of the identified events. Our preliminary findings suggest that, unlike the crisis of 1931, in which macroeconomic and political shocks fed back mutually, from 1933 onwards political shocks dominated. Investors’ sentiment was optimistic from the end of 1933 but turned pessimistic already in November 1935, in coincidence with the crisis of the ruling right-wing coalition.  expectations collapsed after the victory of the Popular Front coalition in February 1936, which markets did not anticipate.’

 

Volatility in an Era of Reduced Uncertainty: Lessons from Pax Britannica

Taking a different view, this article looks at volatility during times of increased certainty during the period now known as ‘Pax Britannica’.

‘Although it has been well established that financial volatility is related to news and macroeconomic shocks, there has been less emphasis on the importance of underlying economic and political stability. In this paper we study the behavior of consol returns since 1729 and identify a greater-than50% decline in volatility from the end of the Napoleonic wars in 1815 until the First World War. News events and macroeconomic variables cannot account for this extended period of reduced volatility. Underlying political stability under Pax Britannica seems to be a more likely explanation, however.’

Stock Volatility, Return Jumps and Uncertainty Shocks During the Great Depression

United States - The Great Depression | Britannica

“There are a multitude of explanations for the depth and length of the Great Depression, of which uncertainty has been proposed as one possible explanation. The 1930s not only saw extreme declines in output and prices, but stock volatility was also at record highs. This high stock volatility was generated by a series of discontinuous jumps as news about uncertainty arrived regularly during the 1930s, as shown by applying the Barndorff-Nielsen and Shephard test for jumps in a time-series.

To provide a more historical narrative for these jumps, I outline some key events during the Great Depression that generated a sense of uncertainty for businesses and households which occurred contemporaneously to these extreme jumps. While much of the literature has placed Roosevelt’s New Deal as a primary source of uncertainty, I do not find much evidence for this hypothesis, and instead find that banking crises, the breakdown of the gold standard, popular unrest and uncertainty related to the brewing war in Europe were primarily responsible for both jumps in returns and the uncertainty of the 1930s.

The author concludes:

“This article has also made the case that uncertainty shocks can be identified by information from securities markets, and that these uncertainty shocks are concentrated in the recession periods of the 1930s. Not only were prices and output falling during this period, but also we can see uncertainty shock events that correspond with these periods of equity volatility and extreme changes in returns as theory would predict. I find, contrary to the existing literature, that New Deal policy changes did not generate large increases in uncertainty, as can be seen by low levels of both overall stock volatility and these discontinuous jumps. Major drivers of both jumps and return volatility during the 1929-1933  great Contraction are primarily banking failures, the breakdown of the gold standard and the threat of an end to capitalism. While uncertainty plays a smaller role in 1938, monetary uncertainty and war jitters help explain this uncertain recessionary period as well. The Great Depression was an uncertain period, which can be seen in large and persistent disturbances to equity markets as well as in the economic collapse of that period.”

 

 

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Jamie Catherwood
My name is Jamie Catherwood, and I’m a Client Portfolio Associate at O’Shaughnessy Asset Management. Get your financial history fix through reading my articles, or those that I link to in my weekly “Financial History: Sunday Reads”.
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