The latest signals of each model are as follows:
- Ultimate market timing model: Sell equities
- Trend Model signal: Neutral
- Trading model: Bearish
Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real-time here.
The stealthy hostage taker
For several months, the market has been gripped by a stealth hostage crisis. The uncertainty of a contested election has gripped the market, and risk premiums have spiked as a result.
The fever seems to be partially fading. Google searches for “contested election” have fallen dramatically.
I have also been monitoring option market’s implied volatility (IV) since late September. For much of this period, IV spiked just after the election, and remained elevated into mid-December and beyond.
These unusual option market conditions have created confusion among traders, which can lead to erroneous interpretations of market sentiment.
Explaining the option market anomaly
The best explanation of current option market conditions can be found in a Bloomberg podcast
with volatility arbitrage trader Kris Sidial, co-founder and VP at Ambrus Group. Sidial explained that institutions had become wary of election event risk, and they have largely hedged using volatility derivatives. Since the market is almost fully hedged, it is difficult to envisage a volatility spike in November.
The entire podcast is well worth listening to in its entirety, but what Sidial left unsaid is worth exploring, and can create sources of confusion for technical analysts. First, the trading of volatility derivatives is not for amateurs and should be left to professionals with a thorough understanding of option math. What Sidial addressed is the institutional market. As the chart below shows, the index volume spike (grey line) shows the hedging activity of institutional investors. However, there has been a surge in single stop call option trading (orange line), which is mainly the province of retail traders.
We can see the divergence in activity between institutional and retail participants in the option market by analyzing the index put/call ratio (CPCI), which is mainly used by institutions, and equity-only put/call ratio, which is used by retail traders. First, the 50 day moving average of the put/call ratio (top panel) is near historical lows, which indicates complacency. In addition, CPCI (red line, bottom panel) is high, indicating institutional nervousness, while CPCE (blue line, bottom panel) is low, indicating retail bullishness. In the past, such high spreads between CPCI and CPCE has resolved with either market pullbacks or sideways consolidations.
What about Sidial’s remarks that a further volatility spike is unlikely because most players are already hedged? That comment has to be taken in the context that he is a volatility trader. While volatility is unlikely to surge, he was silent on the prices of the underlying stocks, or the market. It is entirely possible for the market to correct while the VIX shows little or no upside movement.
Another possible misinterpretation of current market conditions can be found in the analysis of VIX futures positioning. The blogger Macro Charts
observed that large speculators have a crowded short in VIX futures. The conventional contrarian interpretation is the market is poised for a spike in volatility, and an abrupt decline in stock prices. As I have already pointed out, IV spikes just after the election, and remains elevated soon after. Traders are therefore taking advantage of the steeply upwards sloping term structure to sell volatility, and that trade makes sense from a mean reversion perspective.
Current conditions make me mildly bearish on the equity market. Expectations of a Democrat sweep of the White House, the Senate, and the House of Representatives are high. Such an outcome would facilitate the passage of a large and significant fiscal stimulus bill, which would be equity bullish. However, odds of a sweep have been in retreat recently. The market is unlikely to react well to the prospect of a divided government, as it will make the passage of fiscal relief far more difficult.
Much has to go right on Election Night for the bullish scenario to materialize. Any hint of uncertainty, or a contested election, would spark a risk-off sell-off.
What to watch for on Election Night
The election represents a significant event risk to traders and investors. It is impossible to know what will happen. I have detailed the likely effects of either a Biden or a Trump win (see How to trade the election
), but that analysis was based on the assumption of a clean sweep by either party. In all likelihood, the Democrats will retain control of the House. This election is mainly about control of the White House and Senate. Here is what I will be watching on Election Night.
Early in-person and mail-in voting levels are very high in light of the pandemic. Astonishingly, the early turnout in Texas is about three-quarters of the total votes cast in 2016, and Texas is a state that has highly restrictive mail-in voting. Other states that have reported early voting at over 50% of their 2016 total are Vermont, Montana, New Jersey, North Carolina, New Mexico, and Florida.
The two key early states to watch are Florida and North Carolina. Despite the controversy over mail-in voting. Florida has strong systems in place to count early mail-in votes because it is the home to many seniors, who historically have used that method to vote. Florida processes mail-in votes 22 days before Election Day, and a preliminary count should be immediately available on Election Night. North Carolina has reported an early turnout of over 50% of 2016 total votes cast, and it expects that 80% of the votes cast will be counted by the time the polls close at 7:30pm. By contrast, other battleground states like Pennsylvania does not begin to count early voting and mail-in ballots until the polls close, and results from that state are likely to be delayed.
has a useful article on the paths to victory for each candidate. Florida, with its 29 electoral votes, is a must-win state for Trump. If Biden were to score a decisive victory in Florida, the odds of a Trump re-election becomes extremely slim. If Biden were to win both Florida and North Carolina, he is more or less assured of being the next occupant of the White House.
Even if Biden were to score a decisive victory, the bulls are not out of the woods until control of the Senate is determined. Currently, the Republicans hold 53 Senate seats to 47 for the Democrats. Assuming that Biden wins, the Democrats need to score a net gain of three seats to control the Senate and pass a fiscal relief package. Most pundits expect the Democrats will take the Maine, Colorado, and Arizona seats from the Republicans, but lose the Alabama seat. To control the Senate, the Democrats will need at least one extra seat. The most likely targets are North Carolina and Iowa, with Montana, the two seats in Georgia, and Alaska as outside possibilities. Any other outcome that leaves Republicans in control of the Senate will be regarded as short-term bearish.
In summary, the election represents a significant event risk for the market. All the anxiety could be for nothing, much like Y2K, or we could see any number of surprises that sparks a risk-off episode. Tactically, it may pay to position for a reversal. If the market were to rise in the coming week into the election, a prudent course of action might be to sell ahead of the event, On the other hand, significant market weakness could be construed as a buying opportunity.
On an interim basis, the week ahead will be a test for Big Tech. The NASDAQ 100 is testing both the 50 dma and a relative support trend line.
Q3 earnings season earnings and sales beat rates are above their historical averages, though their pace of beats decelerated from the previous week.
Expectations may be set a little too high. The market has punished earnings misses far more severely than their historical average, though the reward for beats was only in-line.
If the Big Tech stocks were to exhibit more misses, then the NASDAQ 100 is likely to violate its 50 dma, and its rising relative trend line. Even though any possible technology weakness could signal a healthy rotation into value and cyclical stocks, this would also create headwinds for the overall market due to the heavy weightings of Big Tech in the S&P 500.