Election Uncertainty

There are tendencies in the financial markets.  These tendencies revolve around investor behavior.  In particular, behavior surrounding hyped up events.  There are very few bigger hyped up events than a Presidential Election.  This event trading phenomena is repeated over and over again in the markets, as written in a blog post about events last year.  The upcoming Presidential election is the next big event.  What has surprised me is how little concern there was regarding the election up until last week, when we had that big one day drop on Thursday.  Once again, it takes negative price action along with event risk to get investors' attention.  Just an upcoming event is not enough.  You need to see weakness ahead of the event to get traders concerned about adverse outcomes.  

Investors are almost always long financial assets.  Their asset allocation will be dependent on the market environment.  The current market environment is an expansionary fiscal policy with loosening monetary policy with little concern about inflation.  This type of loose fiscal and neutral to becoming loose monetary policy is favorable for equities, and somewhat unfavorable for bonds.  That's what's happened over the past couple months.  The upcoming event, the election, will not change the fiscal situation.  Both candidates don't care about the huge government budget deficit, and are becoming more populist.  Both Republicans and Democrats have thrown fiscal conservatism out the window, and are raging spenders and tax cutters.  Throughout the campaign trail, you have heard both Trump and Harris talk about no taxes on tips, tax credits for new home buyers, no taxes on overtime, etc.  

So once the election is over, investors are likely to go back to buying stocks once the uncertainty is eliminated.  This will happen during a very bullish time period for stock buybacks, as November and December are historically very heavy buyback months. Those 2 months account for 23% of buybacks historically.

As for monetary policy, there will be no change over the next year, since Powell will still be Fed chair, but from 2026, the Fed could go in 2 different directions.  Since the markets are so short term thinking, I won't go deep into what could happen from 2026 depending on Trump or Harris winning, but its easy to see a more explosive situation arising if Trump wins and Powell is fired.  

Powell is quite political, and power hungry, as he has shown most recently with the 50 bps rate cut ahead of the election to try to boost the markets higher to help Harris.  If Harris wins, Powell, will have more incentive to be dovish, as he will have a legit chance of getting renominated.  If Trump wins, Powell will realize he has no shot of getting renominated, and will have no incentive to be over dovish as he is now.  

The markets are worried about higher inflation under Trump, as its likely a Republican Sweep if he wins, meaning he'll be able to get more tax cuts passed.  Tax cuts stimulate the economy, as well as blow out the budget, both bad things for bonds.  The bond market has sniffed this out, and has sold off relentlessly since the Fed rate cut in September.  Its clear that bond investors are much more scared of the election outcome than stock investors.  Bond investors remember getting crushed in late 2016 when Trump got elected.  They have PTSD from that episode, and are exercising caution this time around, and are delaying any bond purchases till after the election.  

More recently, stock investors have gotten nervous as the gap between Trump and Harris odds of winning narrows, creating more uncertainty, and a greater possibility of a contested or undecided election for an extended period.  The market hates uncertainty, even if the fiscal policy effects are not that much different between the 2 candidates.  You saw some nervous longs reduce their equity exposure and there have been many more bearish postings on Twitter.  

Over the weekend, you had a poll showing Harris ahead by 3 percent in Iowa, a number that was completely out of the blue, in a historically a deep red state.  It seems like everyone still believes the polls.  The polls have shown in both 2016 and 2020 that they just do not cover Trump accurately.  Trump voters have a much less propensity to participate in these polls.  And it makes sense.  In general, Trump supporters are more anti-establishment than Harris supporters.  Many of them don't like to be involved in polls.  Plus it seems like there are a lot of shy Trump voters.  That is why the polls vastly underestimated his support in 2016 and 2020.  There is no legitimate way for pollsters to correct for these errors.  They can't just put in more Trump votes to try even out the polls and make them more accurate.  They can try to weigh the sample to cover more Trump supporters, but that adds a huge margin for error for the results.  That makes the polls even more useless, as the pollster is pushing his thumb on the scale, to try to come up with a result that he thinks is the most accurate.  

If you look at what issues are the most important for voters, the economy is clearly the most important.  These polls are more accurate than polls over who wins because its less partisan, and don't involve Trump.  Any polls that include Trump will just not be very accurate for the reasons stated above.  With the economy the most important issue, and with more voters thinking Trump is better for the economy than Harris, you should expect a lot of independent voters to lean Trump.  In particular, many independent voters who invest in stocks will naturally lean towards Trump because they will believe that Trump is better for the stock market.  And with the high inflation under Biden, those that are hurting from inflation will also naturally lean towards Trump.  

If you add race, gender, and name value into the equation, they all favor Trump.  It may seem ridiculous, but a lot of voters will vote for who they know, even if they aren't supporters.  That is why incumbents have a natural advantage over a challenger in Congressional races.  Males have an advantage over females.  Whites have an advantage over blacks.  In particular, liberal female candidates are always going to be at a disadvantage in a general election.  They have very little crossover appeal.  That is why you've seen so many right wing female prime ministers in Europe (Thatcher, Merkel, Meloni, Le Pen) and almost no left wing female prime ministers.  Female candidates tend to attract female votes, in addition to party votes.  If most female voters are in the same party as the female candidate, then there are fewer additional female voters (independents and the other party) to pickup.  Since males lean to the right and females lean to the left, there are much fewer female Republican voters to pick up for left wing female candidates.  While right wing female candidates have many more potential female Democrat voters to pick up. 

Harris is the anti-Trump candidate.  Very few will be voting for Harris because they see her as a good candidate.  She was basically anointed as the candidate, with no voting involved.  I doubt she would have won the Democratic primary if Biden had dropped out sooner.  She is not popular.  Its hard to win as an anti-candidate unless you have several factors in your favor.  And she doesn't.  Biden is unpopular, and that gets passed on to Harris, on top of her original lack of popularity.  

Short term, if Harris wins, you likely see a reflexive, mild dip in stocks and a strong rally in bonds.  If Trump wins, you likely see a reflexive, mild dip in bonds and a strong rally in stocks.  I don't expect an extended selloff for bonds or stocks under either scenario.  Bonds have already front run a lot of weakness, so there isn't much more juice left in that short bond trade.  Stocks have corrected most of the post Fed cut rally, and are in a favorable macro environment of loose fiscal, and neutral and loosening monetary policy.  Plus, stocks have strong upward momentum and favorable seasonal factors.  Both stocks and bonds would be a buy on dip scenario if there is a little panic, post-election.  Based on the high VIX readings and the low realized vol, there is a lot of potential vol compression that could happen after the election.  The current COT readings for VIX futures show speculators with a slight long position.  Historically, speculators have held large net short VIX futures positions.  They rarely get long, except during panicky markets, such as Covid panic of 2020, VIX panic in early 2018, and the heavy selloff in late 2018.  I expect a big vol crush post election, which will be favorable for equities as delta hedging from vanna flows will cause dealers to cover shorts.  

Bought the dip last Thursday to get long SPX for the next few weeks, expecting a Trump win.  This is mostly an election trade, looking to catch a post election rally that could last from 2-4 weeks.  Longer term, I remain bearish due to high valuations and high equity allocations.  A post election rally could be the beginning of the topping phase for this raging bull market.  Tops are a process, so expect choppy range bound trading with lots of ups and downs over the next 6 months before the transition to a long term downtrend.