As expected, volatility is ramping up this month as traders deal with uncertainty around stimulus, the election, and rising novel coronavirus infection rates.
Traders tend to “discount” uncertainty in the price of the market.
That means we should expect a rough channel and maybe another short-term correction if investors don’t see some of these questions resolved soon.
While that seems like a sort of dour prediction, we are still reasonably confident that most of these issues will improve in the short term.
Some volatility before the end of the year will allow us to get into more bullish trades on lows and collect higher premiums, but we still want to take this opportunity to discuss the major unknowns so you know why they matter and what might change our outlook.
We were concerned that the stimulus negotiations would be stretched out past the election, and now we think it could take until January before we see something significant come through from Congress and the White House.
Our point of view is that traders are willing to look past the current impasse in Washington and continue to price in the eventual probability that stimulus will be coming in time to support retail, technology and financial stocks, and it looks like investor consensus agrees with us.
The U.S. Senate is now on break, so we won’t likely see anything passed for a few weeks at a minimum.
Although this isn’t the best-case scenario, it seems clear that if investors believed that there was no pathway to a deal, the market would be falling much faster. At this point, we think stalled stimulus talks will put a short-term cap on market gains, but support on the S&P 500 at 3,220 is the lowest we expect the market to fall.
Early voting has now reached half of the vote total in the 2016 election, which is very impressive considering the issues with the Covid-19 pandemic. We have heard from a few subscribers that they have questions about what happens if the outcome is uncertain on Nov. 3.
As we mentioned before, traders tend to discount uncertainty, so we would expect the market to drop in the short-term if the vote is close enough that we have to wait for states like Pennsylvania to complete their reporting. Such a scenario could lead to a delay in the vote count for a few days to a couple of weeks.
The last time we had an uncertain outcome was the Nov. 7, 2000 presidential election between Al Gore and George W. Bush.
The recounts in Florida counties were finally ended by the U.S. Supreme Court on Dec. 12. The initial reaction to the uncertainty was a decline of about 8% in the S&P 500, which is close to what we would expect if there were a few days’ worth of a delay this time around as well.
Some political pundits have even suggested that uncertainty could last for quite a while if President Trump or Joe Biden pursued some other strategy to negate or challenge the results of the vote.
We think this outcome makes for interesting and speculative headlines, but we do not take it seriously. It goes without saying that if something extraordinary takes place, the market would drop severely.
From our experience, nothing would motivate the U.S. Senate and House of Representatives to take action to resolve the matter more than a suffering market/economy.
Covid-19 Uncertainty and Volatility
The reason most market participants (including ourselves) are so focused on the passage of a large stimulus bill is that the economic effects of the Covid-19 pandemic have mostly been kept away from the market because payments and assistance from the U.S. government supported demand — for equities and debt at least.
However, if the U.S. and European economies enter a more severe lockdown this winter, it could be a problem.
Stock valuations are extremely high, so a shock to the economic system could have an outsized effect. For example, according to Yardeni Research, the S&P 500’s forward price-to-earnings ratio (based on estimated earnings for the next 12 months) is 21.1x, which is the highest that it has been since the dot-com crisis.
The “canaries in the coal mine” that we are watching are the Italian and Spanish stock indexes. These two major European economies never recovered from the European debt crisis and so we expect weakness in markets like these to provide some warning for stronger markets like the U.S.
For example, as you can see in the following chart, the iShares MSCI Italy ETF (NYSEARCA:EWI), which tracks the Italian stock market, was positioned at support near $23 per share this morning. If support breaks, we may want to increase our protective strategies.
The Bottom Line on the Upcoming Volatility
Earnings season has so far been overshadowed by drama in Washington and a rising Covid-19 infection rate. However, the drop in earnings has been less than feared, with an actual decline of 13.5% compared to a consensus estimate of a 14.4% decline in July.
It’s still early with only 29% of the S&P 500 reported, but we can usually count on the picture not getting much worse at this stage in the season.
If you had told us a year ago that we would be talking about a 13-14% decline in earnings as a good thing, we would have laughed. However, this still represents a bit of an improvement from the last quarter.
Investors tend to focus on where the fundamentals are heading rather than where they currently are, so this is a vote in favor of stocks. As long as the uncertainties we have discussed in this week’s update don’t worsen, we should still maintain our bullish — if cautious — outlook.
On the date of publication, John Jagerson & Wade Hansen did not hold (either directly or indirectly) any positions in the securities mentioned in this article.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.