[Editor’s note: The following is an excerpt from a recent, longer piece by Kevin Muir, formerly head of equity derivatives at RBC Dominion and better known for his exploits as “The Macro Tourist.” His daily letter is now subscriber-only. The following is reprinted here with permission and is available exclusively to his subscribers and mine. Those interested in trading ideas from Kevin related to the piece below can check out the new MacroTourist here.]
Well, it’s finally here — Election Day in the United States.
I am going to break my rule, and write about politics (a little bit), but before I do, I want to emphasize that it will be solely from the perspective about what it means for the market. I have no desire to convince anyone of what should be done. I am only interested in what will be done.
However, it’s not quite that easy. Trading is not only about forecasting the correct fork in the road, but calculating the odds of that path being taken, while also evaluating the payoff profile if you choose correctly.
Let’s say the market has priced in a 1 out of 5 chance of an event occurring. However, you think the odds are actually 2 out of 5. Not only that, if you are correct, instead of the 5 times payoff profile, you estimate the payoff profile is 10 times. In this scenario, you take that trade all day long (sized appropriately of course). Yet, the important part to remember is that you will still be wrong 3 out of 5 times!
When we discuss the election setup, we need to forecast two items; what the market has priced versus what we believe the odds to be, and the payoff profile based on the different outcomes.
Over the past couple of months, I have disagreed with my finance buddies who claimed that a Biden win was overwhelming expected by the market. They have pointed to the polls and prediction sites to back their argument. A perfect example would be Nate Silver’s site, fivethirtyeight.com.
This might indicate what the pollsters believe, but it is by no means representative of what the market expects.
The scars from the last election are still fresh in the minds of most market folk. In 2016, pollsters like Nate Silver predicted little chance of a Trump win, so when it materialized out of the blue, it caught the market off guard. That’s why the initial evening of trading was so violent. The market was not prepared for a Trump win as pollsters had assured traders it couldn’t happen (or at least the odds were extremely slim).
This time, market participants have compensated by largely discounting the polls. I continually hear talk about how pollsters are once again missing the “shy Trump voter.” I am bombarded by traders sending me pictures of Trump rallies with captions about how Nate Silver is out to lunch.
Almost all of my trader friends are 100% convinced that Trump will pull out another upset win, and the ones who aren’t that confident, are sitting on the sidelines worried that it will be a replay of 2016 (or even worse, a 2000 situation where there is no winner for a couple of months).
And it’s easy to see why. Investors are continually bombarded with bold statements from assured hedge fund portfolio managers claiming that another upset is looming. Here is a quote from the head cheerleader of this movement, DoubleLine’s Jeff Gundlach:
Which brings me to the next part of my analysis. The market has not only overpriced the chance of a Trump win, but has also discounted too high of the probability that the United States will descend into chaos from an uncertain election process.
I have a buddy who tells me that his condo building has created an armed militia to protect against looting during the forecasted post-election chaos. He’s concerned about the fact that the building next door also has an armed militia and wonders what would happen if there are any disagreements between the two groups. Tough to not worry about markets when that’s happening around you.
You know the situation is dire when even Walmart stopped selling guns and ammo for a brief period:
So, before you send me notes telling me how I don’t understand the situation on the ground in the United States, remember that I am not saying that we cannot get a contested election with riots and civil unrest. A good trader never says never, so of course this is a possibility.
The only question is whether the market has accurately forecasted the chances of this event occurring.
Over my decades in the market, I have never seen a financial crisis occur when the vast majority of investors were worried about it.
Recently, I listened to Nate Silver’s interview on Ezra Klein’s show. Previously, I hadn’t spent the time understanding how pollsters were wrong in 2016. After learning how they weigh the different types of voters, it seems clear that the problem of the “shy Trump voter” was not accounted for properly during that election. The pollsters failed to account that college educated voters were more prone to answer surveys, so they believed Clinton’s lead was larger than reality.
Yet, here is my question to current pollster-skeptics: Do you really believe that pollsters have not corrected their models for this problem? If anything, my suspicion is that they have over-corrected. Can you imagine how embarrassing it will be for the pollsters if they once again make the same mistake? Nope. Human nature dictates the odds favoring that they will have gone too far the other way.
So here is my prediction: Markets will be surprised that the pollsters are not complete idiots and can actually accurately forecast elections.
I know this prediction excludes me from the “cool hedge fund” crowd predicting a Trump win in a contested election with all sorts of political unrest. I get it. I know I would sound way smarter if I shared that view, but as my wife likes to remind me all the time – I’m simply not that cool.
However, even if I am wrong, I don’t think the market will be surprised with a contested election. No one will be shocked if we don’t get a victor immediately. Every hedge fund manager in the world has been screaming at the top of their lungs for the past two months about that possibility.
Even as I write this, I am getting notes from my hedge fund buddies proclaiming how “it’s over in Florida and that Trump has won.” And how this means that Pennsylvania is in play and it will for sure come down to a contested election.
I’ll repeat again. A contested election is fully expected by the market.
And let’s address the civil unrest portion. Again, I understand that emotions are quite high right now. There is plenty of animosity between parties. But, let’s not forget that to a certain extent, this is built into American’s DNA. This is nothing new.
Yet, America has always made it through, and will do so again. Do I think there will be pockets of unrest? For sure. Will there be the “revolution” that hedge fund managers are predicting? I’ll take the other side of that trade.
This is hard to write as I will seem like a complete naÃ¯ve fool if I am wrong, but I think the world will be surprised at how well America handles this election. Especially when compared to the absolute rock bottom low expectations.
Listen, is this viewpoint scary? For sure. As I hit the keys, I have gone back and erased it a couple of times, trying to decide how much I want to stick my neck out. Not being a member of the herd – pushing back against all these big time hedge fund managers, is terrifying. If I am wrong, I will be the idiot who just “didn’t get it.” I didn’t understand how America was ripping itself apart. I was the knob who believed the pollsters.
However, I take solace that even if these hedge fund gurus are right, I believe so many of them have placed bets in that direction, their payoff profile will prove way less lucrative than they expect.
When I weigh the odds of their forecast coming to fruition, combined with the payoff profile in the event they are correct, I firmly believe the pessimists have the wrong bet on. It’s not that their forecast can’t occur, it’s just the wrong price.
I continue to believe that owning 1 by 2 VIX put spreads is a great trade in here. I obviously won’t be participating in any of the “election chaos” trades, as I believe the odds of that outcome occurring are way too high and priced too richly.
Feel free to make fun of me, but I’m optimistic the market is selling America short.
Now, don’t mistake that as meaning I don’t think the stock market can’t go down. I have regularly argued that even if you knew the outcome of the election, predicting which way the market will go is still difficult. I have no idea which way the market is headed in the next few days.
My main point is that Wednesday won’t be the start of the next financial crisis – for the simple reason that too many hedgies expect it.