Election Performance Preview: Do Not Expect That Things Won’t be Turbulent

There’s a piece of conventional wisdom in the investing world that elections can get “interesting” for markets. There’s a political axiom these days that every election is “the most important election of our lifetime.” I’m going to avoid these tried and true tropes for the most part because I think anything so tried and true or widely known is already absorbed in to the pricing of assets like the S & P 500 Index.

The evidence for my current concern is actually in the Options market’s expectations for the elections. The positioning for a rough election night is happening even as we speak. There are already moves being made in these markets that imply traders and investors are betting on very high volatility. If it weren’t for that, I might not feel the need to write this.

One Bloomberg article I highly recommend reading to the best of your ability puts it in very clear terms. 1 The article itself hinges on very technical language about a multi-dimensional options trade called a “Butterfly.” You don’t need to know what a Butterfly is to understand the key take away: “In the history of the VIX (Volatility) futures contracts, we’ve never had an event risk command this sort of premium into forward-dated vol at a specific tenor.” Essentially, there has never been a scheduled event with so much pre-speculation and pre-betting on volatility using this yard stick. If this is true, it would seem foolish to expect a limited impact of the events on volatility.

There are two political opponents running for one presidency. The nation might take this to mean we should expect one winner soon after the votes are cast, optimally the night of the elections. That’d be a binary event- there’d be one of two possible outcomes, Biden or Trump as US President.

I’m going to suggest that it is possible this election, unlike past elections, shouldn’t be presumed to be a binary outcome on election night. It may in fact be a non-binary event in which a chain of competing narratives unfolds atop results that are questioned in real time or after the fact. We know ahead of time that due to the preponderance of mail-in voting compared to past years, it is possible that certain states may show one likely winner on election night but shift to another winner over the course of days. Pennsylvania and Arizona are a couple of examples of states where this can happen.2  That doesn’t mean every state that has absentee ballots will be a persisting question mark. The risk that this happens, though, is higher than past elections.

One scenario that could potentially cause a great deal of volatility is the so-called Red Mirage. The Red Mirage is a scenario where Donald Trump appears to win early on- potentially by a large amount- but ultimately loses. 3 This could roil markets as investors hand-wring over the potential for a contested election. One day could show one slate of likely economic policies coming to Washington, D.C. but the next could show the opposite. Or there could be an actual contested election (not something I believe to be likely, but I hesitate to even speculate at all given that I’m a Portfolio analyst, not a political analyst). In any case, it’s safe to say that there is a potential that over a period of days or weeks (or months?) surrounding the election, investors could get freaked out and markets for any number of assets- not just stocks- could get very rocky.

My conclusion on this is that investors should be prepared mentally ahead of time for a non-binary event. A combination of things could happen, or there may be a lack of satisfactory results that could lead to a lot of hanging questions well through the Fall. William Watts said recently that investors are expecting the potentially most litigated election in US history. 4 Walking in to the elections with that expectation is probably a good practice.