Georgia On The Market’s Mind

Equity markets don’t enjoy dealing with exogenous risks. They are extraordinarily good at pricing in risks that directly affect stock prices – things like sales, earnings, cash flow, and the like – but far less adept at a wide range of factors that could impact them indirectly. Political factors are among those more difficult risks for investors.

As we all know, there are two crucial Senate runoffs underway in the state of Georgia. A Democratic sweep would hand control of the Senate to that party, solidifying control of both the Executive and Legislative branches of the Federal government under that party’s control. This would upend one of the stated rationales behind the major indices’ stupendous performances since Election Day – that a divided Congress offers a more market-friendly outcome. A divided Congress would be less likely to approve legislation that results in onerous regulation or higher taxes – two things that investors rightly despise. Why then, with the races too close to call, were investors so seemingly sanguine ahead of an election that could disrupt such an ingrained narrative?

As of yesterday morning, it was my belief that investors were underpricing the risks associated with that potential outcome. In fact, I stated it plainly on a network appearance yesterday that aired just as markets opened for the year. My rationale is quite obvious in the graph below. 

SPX Implied volatility curves for today (dark yellow) and 12/31 (green)

(Click on image to enlarge)

Source: Interactive Brokers

When we closed the year last Thursday, the implied volatility curve for the S&P 500 Index (SPX) options was significantly lower in the nearest term expirations than it was for their longer-term counterparts. After yesterday’s selloff, we see the whole curve priced at higher levels, but the curve had inverted. Short-term implied volatilities, those most sensitive to today’s Georgia runoff and any Electoral College challenges that may arise in Congress tomorrow, rose sharply above those of longer-term options. It was as though the markets had suddenly decided that the “Santa Claus” rally was over and that some risk aversion was indeed now appropriate.

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Disclosure: The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the ...

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