A Political Calculation

I was asked to sum up today’s early trading, and I thought it was best done with a mathematical expression:

              ((End of quarter window dressing) + (Minor but tangible virus progress) + (Renewed hopes for fiscal stimulus) + (Positive economic data)) > ((Debate debacle) + (Layoffs as PPP expires))

Allow me to explain my reasoning. Overnight futures sank sharply as soon as the debate ended, and S&P500 Index mini futures (ES) traded in a nearly 60 point range. Futures had been rising despite announcements of thousands of layoffs from the likes of Disney (DIS) and Dow (DOW) and the near-lunacy that we witnessed during the debate. I awoke to see ES down by about 30 points, only to see them steadily drift higher in the early morning hours. I attribute that to end of quarter window dressing. The next leg higher occurred after the Chicago PMI was released inadvertently at 8:17 EDT, showing a surprising bump over expectations. It is normally released to customers (it is one of the few numbers that is compiled by a private-sector source) at 9:45 and to the public a few minutes later, so both the timing and the result were unexpected. During the morning, we heard positive stories about vaccines from Moderna (MRNA) and Curevac (CVAC) and virus treatments from Regeneron (RGEN). Anything that can help with COVID-19 is and should be considered a positive by markets. Finally, an interview on CNBC with Treasury Secretary Mnuchin shortly before the market open gave hope to those who seek another jolt of fiscal stimulus from Congress. The prospect of additional fiscal stimulus is always greeting warmly by equity markets – though less so by bond markets, which saw rates rise.

All things considered, markets have a difficult time dealing with political risks. Markets are good at discounting events that affect earnings, cash flows, dividends, and other fundamental inputs to stock prices. Yet most political events have nebulous relationships with those key inputs. Stimulus seems like a relatively easy political development for markets to grasp since its effects are purely economic, yet equity markets in August had erroneously priced in the prospect of another round despite an obvious impasse in Congress. The political risk surrounding an election is even harder for markets to grasp, particularly when we have the potential results that are without historical precedent.

At this moment, I consider the VIX futures curve to be the best indicator of the market’s opinions about election risk. We see spot VIX dropping by about 4% today, but the futures are displaying much greater stability. As I noted nearly two weeks ago, before most market commentators, November VIX futures had begun to be priced above their October counterparts. Because VIX is designed to be the market’s best estimate of 30-day forward volatility, the October contract is the one that covers Election Day (it expires in mid-October, less than 30 days ahead of the early November election). As a result, throughout the course of this year – until about two weeks ago – VIX futures displayed their peak level in October. When November surpassed October, that was a signal that options markets were beginning to place a heavier weight on events after the election.

(Click on image to enlarge)

Source: Bloomberg

As others took note of this phenomenon, the popular narrative became that markets feared post-electoral chaos. They are hardly to be blamed. The President has failed to affirm that he would abide by the election’s results, despite having numerous opportunities to do so. This clearly unnerves a large segment of the investing public. Yet that is only a partial explanation for the November bump. The other factor is one of the few political risks that do have a tangible effect on earnings. I am referring of course to taxes.

The surge in November VIX coincided with increasing odds that a “blue wave” could occur, meaning that Democrats could regain control of both the Presidency and the Senate. The Biden campaign has made no secret of their intention to roll back the corporate tax rates to pre-2018 levels and their desire to eliminate the special treatment for capital gains. The former would impact bottom line earnings, the latter would impact investors’ pockets. The change in capital gains could impact investors by 10-15% or more. Few investors expect markets to rise by that amount next year, so investors would be incentivized to lock in gains between the election and year end. Using the VIX curve as our guide once again, we see the December futures that cover the year end also trading above those of October.

I have heard several fellow strategists advise selling the relatively expensive November-December volatility because the market is over-estimating electoral chaos. That may be so, but I think that markets are as focused on taxes as they are on the election. As a long-time market maker, I am quite familiar with the desire to sell relatively expensive volatility. I made a career of selling relatively high volatility and hedging it with something cheaper. But another lesson I learned is that before you make that sale, you had better understand why the market is bidding so aggressively for that volatility. Markets are rarely stupid, and they can usually appear irrational longer than you can remain solvent. If investors are fearful of future tax increases, then they are likely to be quite rational.