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)
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.
Remember, an inverted implied volatility curve reflects a relative shortage of volatility protection. A sea change in risk aversion is one reliable way to turn a volatility curve from normal to inverted in a hurry. Investors suddenly demanded short-term protection, and the options market appropriately responded to that increased demand by raising prices. That is how markets should and do function.
We now have to ask ourselves how much risk aversion is appropriate. Remember, equity markets began to move higher in advance of Election Day even when it appeared that a so-called “Blue Wave”, or Democratic sweep, was likely. That brought the prospect of higher fiscal stimulus, which is an alluring concept to liquidity-driven equity markets. Yet when that prospect proved illusory, markets immediately pivoted to favoring the new narrative of a divided Congress. With 20/20 hindsight (pun intended), it is more likely that markets simply wanted to rally and found a convenient narrative to justify higher prices. If that was indeed the case, we have to question how much of the rise would be at risk if that narrative is upended. A 50-50 split in the Senate (with the Vice President breaking ties) would still make it difficult to enact the sort of sweeping legislation that markets fear most. Within the next day or so we will learn whether market fears of a Democratic Senate materialize, and whether markets are truly fearful of that outcome. Yesterday’s sell-off may prove to have been little more than an overheated market releasing some steam. But at least now, options markets are much more appropriately pricing in event risk for the coming days.
Disclosure: Interactive Brokers
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