The U.S. presidential election has been front and center in the popular press and among retail investors. From the S&P 500 (SPY) to the Russell 2000 (IWM), from the Dow Jones Industrial (DIA) to the Nasdaq 100 (QQQ), it seems equities have been falling precipitously among the uncertainty of the election. Stocks had a longer streak of down days than at any point in the last 36 years—even including the 2008 financial crisis and dark days of early 2009.
For many, this has been tightly correlated with the election, and a large sell-off is the result of worries that the wrong candidate will win. That’s a compelling narrative, it ties into the political drama that is dominating the nation, and it has a certain common sense to it: retail investors, fearful about the future, are selling equities. That selling pressure is putting equities down, and a recovery is likely to come if the right candidate wins.
The short-term trade seems clear: buy short-term calls on SPY, IWM, and any other index you can get your hands on. Short the VIX. Bet on a resurgence of confidence and a return of cash into equities. Easy, right?
Not so fast.
In the institutional investment world, the sell-off has been the result of a very different and arguably more important dynamic: monetary policy. Most institutions have dismissed the election as a side show. The real concern is what the Federal Reserve will do in December.
The market has increasingly expected an interest rate hike to come in December. The probability went from near 60% to over 70% in just a few days. At the end of Friday’s trading, futures priced in a 72% probability. On Monday morning, futures lowered that probability to 67%—and equities went up at the same time.
We only need to go back a year to see how equities respond to an interest rate hike. When the Fed confidently pronounced a strong American economy in December 2015 and raised interest rates 25 basis points, stocks slumped, junk bonds crashed, and just about everything was red for a while. Before the pronouncement, the downturn was even more severe.
If the “right” candidate wins the election, there might be a short-term sigh of relief and stocks might have a strong day. Indeed, Monday is prepped for such a day. But short-term movements are not trends. In reality, the certainty of the election might remove a small amount of selling pressure from retail investors, but then the real attention will return to monetary policy. The Fed has given strong hints that it will raise rates. Will the market continue to feel relieved in the face of higher borrowing costs, even after the election uncertainty is over?
The reality is no one really knows. There can be no certainty of a resurgent market turning into a strong rally. Instead, we will need to see how the market responds to the Federal Reserve. That’s where the real action is, as far as the stock market is concerned; the White House is a sideshow that can cause some short-term volatility, but its staying power in equity valuations is tiny.