How to trade the post-election melt-up

Posted by Cam Hui -
Mid-week market update: I pointed out on the weekend (see A final update on the Trump Trade: Tail-risk assessment) that the term structure of the VIX had inverted, indicating high levels of market anxiety. The market was hedging for a catastrophic outcome that turned out to be nothing. Today’s post-election rally is mainly attributable to a positioning unwind of an over-hedged position. “Bloomberg reported that “Wall Street Quants Set to Buy $50 Billion in Stocks as Volatility Falls”.

 

 

What’s next?

 

 

The good news

Here is the good news for equity investors. Jurrien Timmer at Fidelity studied the two and four year post-election returns of the S&P 500. If history is any guide, stock prices will experience one of the strongest returns if the Republicans sweep the White House, Senate, and House. While the final tally for the House is incomplete and won’t be known for some time, they appear to be well on the way to a sweep, according to the Cook Political Report.

 

 

Tactically, the post-election melt-up can be explained by the unwind of hedges. It’s difficult to tell how far it will run, but the market isn’t overbought yet. So enjoy the party.

 

 

Valuation pressures

More concerning is the bond market’s reaction. The S&P 500 trades at a forward P/E of about 22, which is well above its historical average.

 

 

The surge in the 10-year yield in reaction to Trump’s victory will undoubtedly add to valuation pressures. In the short-term, valuation doesn’t matter much, though it is an important determinant of long-term returns.

 

 

The key question is how does the Fed react to these market conditions? Not only has the 10-year yield risen by 15 bps, the 2-year yield, which reflects market expectations of the Fed Funds terminal rate, rose by 8 bps. The market expects the Fed to cut by a quarter-point tomorrow and another quarter-point at the December FOMC meeting. Will Powell offer any guidance to the Fed’s reaction function at tomorrow’s press conference?

 

 

 

Stay tactically bullish

For now, my inner trader is staying tactically bullish. The relative performance of junk bonds (dark solid line) is tracking the new all-time high of the S&P 500.

 

 

The positioning unwind will play itself out in the coming days and weeks. It’s too early to be taking profits. The usual disclaimers apply to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

 

 

Disclosure: Long SPXL