Thursday, June 12, 2008

Statistical model predicts a McCain victory?

There has been a lot of buzz lately about a simple statistical model proposed by astrophysicists Prof. Gott and Dr. Colley that uses the median polls of each state to predict the November electoral vote. (For our un-American readers, the electoral vote is what determines the outcome of a general election, not the popular vote, in case the nightmarish 2000 election has not already drilled this fact into the world's collective consciousness.)

Dr. Colley has set up a website to track daily such polls to gauge the mood of the states. The authors have tested this method on the 2004 election, as well as numerous sporting events outcomes, and found it to be highly predictive.

Right now, they are betting on a McCain victory.

But there is one caveat that many bloggers have pointed out, and it is the same caveat that I have previously applied to the predictive accuracy of political futures market such as intrade.com. The caveat is this: polls (and futures market) change with time. And at different times, they predict different election outcomes. So for example, at this point (June 2008), the polls predict a McCain victory, while the futures market at intrade.com predicts an Obama victory. Who is right?

The answer is: neither. As Dr. Colley has explained to me, no backtest as far back as the June of an election year has been conducted. (Their research was based on polls from September onwards.) So we do not know if the June polling prediction has any accuracy. Similarly, as I pointed out before, the futures market can swing violently even on Election Day, even in the last hours of an election.

One advantage of the Gott and Colley method though, is that the predictions resulting from median poll statistics are remarkably stable over time. In 2004, there was very little movement in the electoral tally from September through election day. Extrapolating this result, we can be somewhat more confident of their prediction vs. Intrade.com's, even at this early date.

And in any case, I have observed that the political futures markets are highly mean-reverting, implying that the current large 20 points spread between the Obama and McCain futures is destined to decrease in the coming months.

As an arbitrage trader, I have therefore proceeded to short the Obama future.