Watch Market Volatility Rather than Direction Around Election
- A remarkably consistent decline in markets - most notably S&P 500 - does not speak to conviction
- Risk aversion due to US election uncertainty does not offer a secure trend
- In contrast, unprecedented volatility risk heading into this event does suggest limits
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Despite the general sentiment surrounding the forthcoming US election (Tuesday the 8th), there are a range of outcomes that could develop after the fact. There are those operating under the assumption that the slide in confidence via benchmarks like the S&P 500 this past week is a signal of an inevitable trend that will only be accelerated after the numbers are in. Then there is the traditional speculative lot that think fear is reaching beyond reasonable bounds and a rebound is in store. The ultimate outcome is variable. The market's interpretation of the path we follow is also up in the air. Conviction in the face of these uncertainties is highly risky. However, there may be a more probably course.
While direction and market reaction is difficult to assess ahead of such dynamic events, there is more familiar course in the form of short-term volatility. Uncertainty heading into high profile event risk can grow to extreme levels. The variety of possible outcomes and the scale of possible volatility reactions leads cautious investors to 'hope for the best and prepare for the worst'. For pricing, we see that translate into extreme, short-term implied (expected) volatility measures. While there are times when the outcome actually exceeds the median 'worst case scenario' pricing (like the Brexit), more often it falls short. And, what follows is a fast deflation of risks that speculators take advantage of.
Looking at volatility metrics like the VIX, we can see that the rapid build up of pressure leading into the four-year event is unprecedented as far back as we have data available for the popular product. Furthermore, short-term volatility relative to a more distant outlook (one week versus four week) is rising to levels comparable to the realized market collapses after the Brexit and during the August 2015 plunge. Those are extreme expectations that could prove difficult to live up to given the different assessments that will be made of the outcomes. While this does not mean that risk trends are likely to be turned for a lasting recovery after the US election, short-term pressure relief is likely. We discuss this aspect of the impending event in this weekend Strategy Video.
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