- “There are plenty of reasons for investors to worry about post-election chaos.” – The Economist (Oct 10, 2020)
If the outcome of the Presidential Election remains unclear for an extended period, how would it impact the stock market?
The Economist is nervous.
- “The democratic cycle, for all its virtues, tends to bring with it a dose of uncertainty—first about who will win and then about what that victor will do. And uncertainty tends to make financiers nervous.”
The Financial Times foresees “havoc” and warns that “the stability on which markets depend is at risk.”
Technicians point to spiking patterns in recent market volatility – signaling the “worst event risk in history.”
And everyone remembers (or thinks they remember) how the market collapsed utterly during the Bush vs Gore episode in 2000.
Or did it?
Let’s look at the 2000 case first.
Bush v Gore
The 2000 Presidential election was decided by 537 votes in Florida (out of ~100 million total ballots cast in the U.S.). The result was of course contested. Recounts were ordered, debated, challenged, halted, restarted, challenged again. The matter wound through the courts, prolonging the uncertainty for 35 days until Supreme Court effectively declared George W. Bush the winner. It was a period of electoral chaos without parallel since the 19th century.
The Economist would have it that the uncertainty staggered the market.
- “Markets dropped by 1.6% the day after the election as it became clear there was no decisive winner. The S&P 500 sank by more than 8% by the end of the year.”
But is this a proper characterization of what really happened?
In the week that included the 2000 election – the period when the uncertainty was injected into the financial system – the market was down 4.3%. However, the week that included the Supreme Court’s decision resolving the election – which presumably removed the uncertainty from the system – also saw the market decline by 4.9%.
There was a larger financial context – stock prices were already sliding down in the first leg of a huge bear market cycle, which began in the late summer of 2000 and continued for two more years. The S&P 500 fell 23% in the 7 months bracketing the election, and was down 47% over the next two years. In context, the decline of 3.6% over the 35-day span of the electoral uncertainty is better seen as a small step in this long downward time-series.
In fact, during the 4 weeks between the end of the election week (when the surprise or shock factor had been absorbed by the market) and the court’s ruling – 4 weeks when the matter was unresolved, events were quite confused, and presumably the uncertainty was highest – share prices actually rose.
In other words, for more than a month, while the political process went through a tortuous and unprecedented series of maneuvers by all parties – recounts, disputed ballots, lawsuits, injunctions, impoundments, court rulings, court over-rulings, media frenzy – the stock market appears to have been… unperturbed. There was no collapse. No panic.
So, market context matters. The Bush v Gore record does not actually support the idea that the markets are inevitably disrupted by this sort of electoral uncertainty. Markets move in response to “events” – news, surprises, shocks – but they are also borne along on larger financial and economic trends. In the election of 2008, for example, the market fell 11.6% in the 35 days following the election. It would obviously be incorrect to interpret this steep decline as a symptom of electoral uncertainty – there was none in 2008. The decline was a part of the vast downward plunge of stock prices from Sept 2008 through March 2009.
A month ago, the financial headlines were on fire: U.S. Election Priced as Worst Event Risk in VIX Futures History.
- “ ‘In the history of the VIX futures contracts, we’ve never had an event risk command this sort of premium into forward-dated vol at a specific tenor,’ Bloomberg macro strategist Cameron Crise wrote in a blog post. “That obviously suggests that markets anticipate some pretty incredible fireworks….That could be a sign that punters are worried about 2000-style uncertainty. You don’t need a particularly vivid imagination to think that that could get pretty ugly this time around.’ ”
(Worst In History! I’m not sure I know what “forward-dated vol at a specific tenor” is supposed to mean, but you get the idea. A scream is a scream.)
So what is the VIX and why do we think it forecasts trouble ahead when it rises? (What follows is a simplified account.)
The VIX is an index that measures the volatility of the stock market. The higher the volatility, the higher its “price.” Since the volatility, and the VIX, often go up when stocks go down, buying financial instruments based on the VIX is seen as an effective hedge – a kind of insurance – against a downturn in the market. This is why investors have paid such close attention to the VIX and instruments derived from it. In particular, The Economist cites VIX Futures prices as a signal of expected market distress in the coming period. The rise in prices cited by the Bloomberg analyst is, for him, a decisive signal of a looming “event risk” – and the event in question is interpreted to be the prospect of chaos in the upcoming Presidential election.
One way to interrogate this metric is to examine the “term structure” of the VIX futures over the coming months. The chart below shows the prices, as of Sept 29 this year, of VIX futures expiring in 1 month, 2 months, and so forth – up to 5 months out (February). It is interpreted as showing a significant premium – perhaps 10% – paid for extra downside protection in November and December. Indeed, there is a meaningful price premium for futures contracts out to the the middle of the 1st quarter next year. This heightened demand for “insurance” is read as a sign of investor anxiety over the possibility of a contested or uncertain election outcome in Nov/Dec and perhaps beyond.
But this may give an inaccurate sense of the stability of these expectations. After all, Volatility is…. well, volatile. This year the VIX has been especially jumpy. In March it spiked to an all-time high of 85 as the Covid crisis impacted the markets. More recently, it has bounced around in response to various “shocks” – some of which are clearly political in nature.
In any case, just a few days after this chart was constructed, VIX Futures prices began to tumble.
It is not unreasonable to read the VIX, and perhaps especially the VIX futures that cover the period of the upcoming election (Nov/Dec), as a measure of political anxiety. But does it have predictive value? The VIX itself has now fallen back towards its long-term average of about 21-22 (it is trading the past few days at around 25). VIX futures have eased down as well, and are back at the August levels. We might conclude that the market is now “betting on less, rather than more, chaos” (as The Economist piece rather lamely concludes). Or maybe it has simply adjusted to the momentarily stressful new information.
Past political events have caused short-term spikes in the VIX and futures prices. In 2016, VIX November futures soared 55% in three hours on election night when the shock of Trump’s unexpected victory started to sink in. But by noon the following day the price was back to where it had been 24 hours earlier.
The key question again is – context. Is a rise in VIX futures a valid predictive indicator of some sort of extraordinary looming political distress? Or is it more like an adrenalin surge of fear or surprise, quickly subsiding as the system adjusts to new information?
Or is it also to some degree a natural part of “the democratic cycle” that the authors of The Economist piece refer to?
I have found one study published originally buy the National Bureau of Economic Research which looked at the relationship between election cycles and the prices of put options. Put options are another way to hedge or insure against downside risk in the stock market, and probably track the same sentiments that drive VIX futures prices. Examining 271 democratic elections in 20 countries, the researchers found a persistent and significant price premium paid for options that straddle the period of a national election. Options that were significantly “out of the money” had the highest price premium – suggesting that investors were truly hedging so-called “tail risk” (the likelihood of extreme or unusual or unexpected outcomes). In other words, it seems that investors do routinely take out insurance at election time.
Thus, the information content of these metrics – VIX futures, Put options – may reflect a confluence of several streams of investor sentiment:
- future expectations regarding the specific risks of a specific upcoming event (e.g., a contested election)
- “surprise” jumps in response to striking news events, which quickly fade as the information is processed and discounted (e.g. the President’s Covid diagnosis)
- systematic hedging related to regular transitions in government
One final comment on all this. As noted in the previous column, markets mutate. The meanings of the signals emanating from financial instruments mutate. This applies especially to recent financial innovations, like the VIX. VIX has been a tradeable product for only about 15 years, and its rise to prominence in the market is a phenomenon of the post-2008 period. The uses of volatility-links financial instruments have been evolving rapidly, and it is likely that the “meaning” of the VIX, and its predictive value today are not the same as even a few years ago. Hedging concepts and techniques are also evolving. It is a stretch to say that investors “played” the elections of, say, 1992 or 2000 in the same way as they may play the election of 2020.
It seems like common sense to think that uncertainty of any sort must be bad for the stock market. But as noted in my previous column, common sense and market realities don’t always align.