MorningWord 10/10/16: Electioneering

by Dan October 10, 2016 10:15 am • FREE ACCESS

As unpredictable the first half of 2016 were in financial markets, the back half is proving to be stranger.  The 12% peak to trough decline in January & February caught most off-sides, and then again with the post Brexit vote reaction in late June. Following the V reversal, few probably thought it possible that the S&P 500 (SPX) would trade in a 50 point (2.5%) range for most of July & August with record low volatility. Nor when the range finally broke, it would do so because of politics, not economics.

It’s been my view that the unpredictability of Trump presidency would be a de-stabilizing market force versus the predictability of Clinton’s. Owners of risk assets seem to agree. And the predictability of the election itself also seems to be a factor. Although it’s impossible to attribute 100% causation, markets seem to have been strongly correlated to the polls over the past few months. In Q3 we saw financial markets reach an unprecedented level of calm but then sell off in Sept as the race tightened, and then calm once again as Clinton regained a healthy lead in the polls. Alongside a status quo bias for the election, financial markets have also benefited from a status quo monetary policy from the Fed. Although they deny any relationship, it’s pretty clear they don’t want to make any sudden moves until everyone has voted (this is less them “picking” a winner than a timing issue that’s backed them into a default setting). That’s resulted in a very predictable FOMC (despite some short term palpitations of tightening probabilities on a meeting to meeting basis). It has been my view all year that once we got into the second half, the only real LIVE meeting would be December. So while financial news, finance twitter and some rates traders hoped otherwise, the Fed is NOT raising months or days before the presidential election.

If Clinton’s lead stays constant or even grows, we’ll have a good sense of the margin of victory on November 8th and that should keep markets fairly calm. But then I think there are a couple ways things could play out. (Spoiler Alert, both involve new highs.) If we have already made new highs in the SPX into the election, then maybe we see a “sell the news” after Nov 8th. If investors try to get a jump on that theory and we sell off prior and find support where the index should (2100, then below that 2066), then I suspect we see investors buy the dip as they have time and time again over the last 7 years and push to a new high into December.

But then we get to Dec 14th, the FOMC’s last meeting of 2016. Fed Fund futures are pricing a 65% probability of a raise. That would be only the second raise in about 10 years. I suspect financial markets take it stride and that the SPX closes the year above 2100, possibly above 2200 at new all time highs. But in Q1 2017, all bets are off. (I’ll save that for another post).

So we have 3 clearly defined events, Nov 2nd FOMC meeting, Nov 8th election and Dec 14th FOMC meeting. I expect all to go as planned. No raise in Nov (but language suggesting Dec raise), Clinton win, then Dec raise. That’s all fairly predictable and if it happens in that manner, it’ll just be a matter of when investors take markets to a new high and then how they react once that happens.

The at the money straddle in the SPY between now and Dec 16th is suggesting a little more than 4.5% in either direction. With the etf around $217, the Dec 217 straddle (the call premium + the put premium) is offered at ~$10. If you bought that and thus the implied movement you would need a rally above $227, or below $207 to make money by Dec 16th expiration. I would be surprised given my expectations for upcoming events for the SPY to be too far below or above that range between now and then.

While many might suggest buying protection with options prices so low, given the potential political uncertainty, the best trade on the board might be to play for further consolidation and sell the move. Obviously, that is an entirely domestic view on our markets and there’s always the chance of an foreign story coming into focus.