A new leader takes power. They restore order to a country and embark on an ambitious series of political reforms. The economy is expected to improve as businesses become more confident, investment increases, and the country becomes more competitive. Investors, not surprisingly, will pile in, hoping to ride the boom.
In fact, however, they will be making a mistake. According to a fascinatingnew study by Helios Herrera, Guillermo Ordoez and Christoph Trebesch, political popularity is the best single indicator that a market is about to crash. Instead of getting in, investors should be getting out of countries where political leaders are riding a wave of support.
There has always been an intense debate about what causes markets to crash. It is certainly important to get it right. Avoiding the big crashes is the best way to improve the performance of your portfolio.
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Some commentators argue that collapses are created by unrealistic stock market bubbles. Others pin the blame on an unsustainable build-up of credit. A few look to the underlying business cycle, arguingthat growth always starts to declineevery few years, and the markets will follow it down.
But this new study argues that none of those events are the best predictor of financial crashes. Instead, it is political bubbles you should watch out for. Herrera, Ordoez and Trebesch examined a series of financial crashes in the past 50 years and found that when a government was very popular, there was usually trouble ahead.
This was particularly true in emerging markets, where there was typically a very strong rise in the popularity of a government ahead of a crash, although far less so in developed markets.
The reasons are not hard to figure out. Popular politicians have usually embarked on rash spending sprees, or made a lot of easy promises they can't keep. If a dangerous credit boom is building up, they won't have taken any measures to prevent it. Hard decisions have been shelved. That damages the economy and leads to a crash and huge popularity is the best early clue.
It is a plausible theory, which isbacked up by some compelling evidence.So far, it only really applies to emerging markets. But increasingly, politicians in the developed world are opting for the same kind of populism.
If Herrera and his colleagues ran the same data through their computers in ten years' time, it would not be surprising if it applied to wealthy countries too.
A theory is just that, however at most an interesting idea. It is only valuable if you can use it to work out where the next round of crashes might happen. So if it is right, which countries should we be getting worried about, and which ones should be making us more confident?
For starters, sell Germany and buy France. The German chancellor, Angela Merkel, has never been more popular. Her coalition government has a 59% approval rating right now, while her own ratings are at 79%. However, Merkel has increasingly been taking the easy option.
Reforms have been dropped, and the government has just introduced its first minimum wage. Nuclear power has been abandoned, with no real plan for what will keep German factories running for the next decade.
The euro crisis has been allowed to drift because fixing it involves tough decisions. This is precisely the kind of short-termism that creates trouble sooner or later. France's Franois Hollande, by contrast, could hardlybe less popular.
The French president has approval ratings that are so low they can hardly be counted. He is widely ridiculed as the most useless leader of the Fifth Republic. But and here's the catch at least France is starting to ask thehard questions about whether itsbig-state model is still sustainable.That's a start. Perhaps it will improve from now on?
Next, watch out for Turkey. Outgoing prime minister Tayyip Erdogan has just been elected as president with huge popular support. But the economy remains very fragile, and it is only a year since the markets last crashed.It might happen again.
Likewise, Italy's youthful new prime minister, Matteo Renzi, has proved hugely popular. But the country is sliding back towards recession, and the investors who have piled into Italy in the last few months could get burned.
By contrast, there are some unpopular leaders out there, whomay well be doing the right things.Take Shinzo Abe in Japan. His ratings have been sliding in recent months. Perhaps he really is getting to grips with that country's never-ending recession. Or Barack Obama his ratings are at an all-time low, suggesting the US recovery may be durable.
As for this country, all our politicians seem to be equally unpopular right now, which would suggest the country is muddling through quite well. After all, the last really popular leader we had was Tony Blair and soon after he left Downing Street, the economy crashed, which confirms that this theory may have some truth to it.
And even if none of these predictions turns out to be right, this is certainly a fascinating new theory.
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