On Election Eve, Divorce Investment Decisions From Political Ones

Has the stock market become the new election poll, and if so, what is it telling?

That adage of avoid politics and religion comes to mind. But when managing other people's money, the election is their net worth because the outcome has major global asset market implications that could impair five-to-seven year returns.

And to say that that in and of itself can end up ticking off everyone in the equation, which is the why the advisory community is quiet when it absolutely shouldn't be.

The claim that a victory by Republican presidential candidate Donald Trump is beginning to reflect itself in markets is inferred by supporters of Democratic presidential candidate Hillary Clinton to mean that he might win. That isn't an outcome some can accept.

But saying a Trump victory would have negative implications for the market roils the other side. However, it doesn't have to mean that he is necessarily bad for America or the economy.

Why?

In the words of famed fund manager Stanley Druckenmiller, six years of Federal Reserve-fueled low interest rates have driven asset prices higher with very little positive effect on the economy.

They certainly haven't helped the personal household balance sheets of the middle class.

It is mainly the 1% to 5% who own stocks, so why would a vast majority of America care what happens to the market?

Here is where global players could make the same mistake as was made with the Brexit. Although some abroad look aghast that the U.S. could possibly elect Trump, there is similar anger among Americans as existed among many in the U.K.

Is the placement of a Trump victory on the distribution spectrum and its proximity to the bell curve center, priced into the foreign-investor mindset?

Chinese equities and the Mexican peso are the canaries in the coal mine when it comes to prognosticating a Trump victory. One of them has stopped chirping.

But Trump's greatest market risk perception is his perceived abandonment of Fed Chief Janet Yellen and the unprecedented easy money policy since 2011. Repeated bounces off of major market draw-downs were enabled by Fed speak, i.e. the dovish pullback from expected rate hikes and the Fed-forward dot matrix.

Will Fed speak save us? If Trump wins, what does Trump speak indicate?

It says the markets are rigged, the Fed is political and Yellen has to go.

Are we market players nervous that, unlike his idea of a wall along the border with Mexico, that Trump might be serious about this one? Or worse, are we afraid to admit that he could be right, and (gasp!) we might agree with him?

But we don't need a view about who to vote for to say that this market presents major risk.

We just need an expected value analysis: assign a probability of each outcome multiplied by the perceived after-market effect, and add the sum. It is negative for us.

As a research note from Citigroup said last week, a Clinton victory "will be marked by near continuous investigations and impeachment risk."

Worse, a popular vote win by Trump and an electoral win by Clinton would mark a contested election, and though Constitutionally valid, would generate a continuous negative headline loop that batters foreign-investor mindset like a piñata.

The only outcome that would have a positive market effect would be a Clinton victory with no charges or investigations, no continued strife with Congress or the Federal Bureau of Investigation, and forcing Yellen to back off a rate increase next month.

A Clinton victory is still near the center of the bell curve, but what about the Fed once again, for the umpteenth time, departing from its stated path of raising rates? Where is that outcome on the bell curve?

Pretty far down the tails.

To add insult to injury, we have that giant gorilla in the room, called negative gamma generated by the three new dominant investment strategies. Negative gamma is a type of portfolio risk where exposure to the asset class increases the lower that asset class prices go.

The three strategies with dangerous negative gamma are:

1. Risk parity, where changes in implied volatility lead to the buying of an asset when its daily movement subsides. That also means an investor sells it when the volatility as measured by the CBOE Volatility Index, increases.

Some pretty smart guys like Ray Dalio, founder of investment firm Bridgewater Associates swear by risk parity. 

2. Pension fund enhanced-yield strategy, which despite being invented by quants, was something we former floor option guys used to just call selling straddles. Another name is Russian roulette.

These remind me of credit default swaps, which almost took down the system and created an implosion of the U.S. investment-grade credit markets. The theory was fine, but the structure had faults and generated dangerous technicals from the automatic unwind triggers inherent in the product.

3. Passive investing, a strategy with embedded negative gamma not in its structure but in the mindset of the passive investor. Behavioral finance is the relevant science here.

Momentum can infect strategies as much as stocks, and this one is guilty of a herd mentality.

How is it negative gamma? Downward moves beget additional selling by the investor.

His or her perception of the risk, rather than actual risk, increases the lower the markets move.

We haven't yet triggered this negative gamma lurking in these equities markets. Will this be the time?

It is hard to say, but it could be the closest shot across the bow we have had.

What saved the market after the Brexit? Negative rates abroad, feeding in the models and structures, leading quants to lift equities and generating the false positive feedback loop that the Brexit didn't matter fundamentally.

Will Fed speak save the day again? Will flight-to-quality buyers dominate the U.S. Treasury market.

Or will Trump speak trump Fed speak?

For us, the sum of the expected values is negative. We have raised cash positions to more than 50% and put on long volatility, downside bearish put spread positions, which despite paying up for volatility, exploit a decent volatility skew.

It is time to divorce investment decisions from political ones and for the advisory community to cease being quiet.

This article is commentary by an independent contributor.

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