Something Big Is About to Happen

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Originally posted at Briefing.com.

November 8, 2016, may not be a day that lives in infamy, yet the path to that day—Election Day—sure has been an infamous one. The presidential campaign has been reality TV at its finest—and that's not a compliment.

Whether you like it or not, though, things are about to get real. A new president will be elected (we hope), which means something big is about to happen in the world, and, for our purposes here, in the stock market.

A Disclaimer

Last week we reminded readers that Briefing.com does not take positions when it comes to politics. We feel compelled to provide that reminder again today, primarily because we will be talking politics in the framework of this week's column.

Read A Subtle Election Connection

The disclaimer is that the political views presented here are a summary of the political narrative that has had a grip on the stock market for the past several months and the last week in particular.

That narrative is necessary to share as part of the context for our assertion that something big is about to happen in the stock market. With that, let's begin.

The Summary

A few weeks ago, the stock market wasn't doing much of anything. It was moving sideways in a laborious fashion, doing so we would add at a time when the conventional political wisdom suggested Mrs. Clinton was likely to win the presidential race and that Congress, most likely, would see Republicans maintain control of at least the House of Representatives.

Such range-bound action indicated to us that either the market wasn't totally convinced of the election outcome, despite what conventional political wisdom was suggesting, or that it wasn't totally convinced anything really positive over the long-term would come from the election.

In any event, the conventional political wisdom implied there wouldn't be a political mandate for either party. There would be continued political gridlock—an idea the market reportedly prefers since it reduces the element of uncertainty that would arise with either party having control of both the executive and legislative branches of government.

Still, there were enough rumblings about the possibility of a Democratic sweep that the market maintained a cautious-looking posture.

Last Friday, however, changed the market's perspective. The revelation from FBI Director Comey that an investigation was being conducted of a new batch of emails sent by Mrs. Clinton from a private server during her time as Secretary of State seemed to put a wrench in the conventional political wisdom.

Subsequently, there has been a tightening in some political polls that has made the Election Day outcome less certain in many participants' eyes and has elevated the possibility of a Republican sweep of the executive and legislative branches.

A number of pundits have suggested the stock market will have a significant setback if Mr. Trump wins the presidency, partly because he has a stronger protectionist bent than Mrs. Clinton and partly because he would foster a stronger sense of uncertainty in the stock market since he is a political outsider. Mrs. Clinton, on the other hand, gets billed as being a known political entity.

In more colloquial terms, the market reportedly sees Mr. Trump as the box of chocolates and Mrs. Clinton as the Hershey bar.

Four Shades of Grey

With the election right around the corner, the element of uncertainty is quite high, and time and again we are reminded that the market does not like uncertainty, particularly when that uncertainty involves a heightened risk of a negative outcome.

What would such an outcome be? If the pundits are to be believed, it would take on one of four shades of grey:

  1. A contested presidential election
  2. Mr. Trump winning the presidency and Republicans controlling both the House and Senate
  3. Mr. Trump winning the presidency and having a split Congress
  4. Mrs. Clinton winning the presidency and Democrats controlling both the House and Senate

Market participants are preparing for a negative outcome in a prudent manner. Cash is being kept on the sidelines, equity exposure is being reduced and cash levels are being raised, and options are being purchased to hedge against downside risk.

None of that means necessarily that the worst-case scenario is going to unfold. Brett Manning, Sr. Market Analyst for Briefing.com's Trader service, used an apt metaphor, likening the defensive positioning to Florida residents making preparations when a tropical storm has been upgraded to a hurricane within a couple hundred miles of shore.

Sometimes the hurricane hits directly, but sometimes it veers away and little or no damage is done. The important point is that proper precautions were taken ahead of time to minimize the risk of loss.

What It All Means

The stock market action more recently has become increasingly governed by a lack of buying interest more so than aggressive selling interest. The numbers bear this out.

The S&P 500 declined for eight straight sessions, starting October 25. Over that span, the S&P 500 declined 2.9%. That's not an insignificant move in that period of time, but relative to the huge gains that have been logged during this multi-year bull run, it's not a rush-for-the-exits kind of move either.

It's a hesitation trade in front of a supremely newsworthy catalyst (i.e. the election outcome) that many participants believe will produce a binary trading outcome. Hence, there is a healthy level of respect right now for near-term downside risk that is being offset somewhat by a fear of being totally out of the market in the event a relief rally ensues on the other side of that news catalyst.

The respect for the possibility of a big relief rally is predicated on numerous instances during this multi-year bull run when stock prices have rallied sharply in the wake of worst-case scenarios being avoided.

We don't have any more prescient insight than the next outfit on how the market will trade post-November 8. It will do what it chooses to do when hard facts are known versus the relentless speculation that exists today.

Our assumption is that it will stage a big relief rally in the near term if the hard facts point to political gridlock with Mrs. Clinton as president and Republicans having a majority in one house, if not both houses, of Congress.

It will do so presumably because that reportedly preferred scenario hasn't been seen of late as a given and it will do presumably because a number of contrarian indicators are lining up in that favor.

Cash levels among fund managers are high, the put-to-call ratio is high, bullish sentiment among individual investors sits at 23.6% versus an historical average of 38.4%, according to the American Association of Individual Investors, and efforts to hedge against any near-term downside have escalated, evidenced by the 60% surge in the CBOE Volatility Index since the start of October (and 32% in the past week alone). This is all evidence of investors waiting for something bad to happen, so if it doesn't, a change in positioning should benefit the stock market.

cboe put call volatility

Moreover, there has been a welcome pickup in earnings growth that has been completely overshadowed by the election uncertainty. If the latter uncertainty is removed in what is believed to be a favorable manner, the improved earnings picture should soon resurface as a supportive market driver.

The risk is there, though, for the market to have a big, near-term sell-off if the election does not get resolved in a manner the market deems favorable. That belief is tied to the understanding that, despite all of the reported nervousness dotting the stock market landscape at the moment, the S&P 500 is still only 4% off its all-time high.

Even if the stock market doesn't have a big response to the election outcome, the election itself will still be a big deal since it will usher into office a new individual as leader of the world's most powerful nation.

That leader could be the nation's first female president, which would be a big deal from an historical standpoint, or that leader could be a businessman, reality TV star, and political outsider turned president, which would also be history in the making.

Any way one looks at it, November 8, 2016, is going to be a big day filled with big news and possibly a big stock market reaction.

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About Patrick O'Hare

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