@theMarket: As Election Approaches, Markets' Volatility Should Increase

Investors are increasingly preoccupied with the general elections, which are less than three weeks away. That focus should increase as we go down to the wire, and as it does, so will volatility.  

 

It is getting harder to ignore the election contest. The media, both mainstream and social, spews out a continuous stream of political news. I finally shut down my X account this week because of it. Although difficult, my attention remains focused on the market and not the election.

 

This week, third-quarter earnings have kicked off, and results have been strong thus far. Of the 58 companies reporting thus far, 76 percent have beat estimates. Banks have surprised to the upside. Revenue growth has been tracking at plus-5 percent, within the 4 percent to 5 percent growth rate we have seen over the past eight quarters.

 

Why is that important? Many pros have been arguing that as inflation falls, so will corporate sales, insisting that much of the sales gains have been the result of price increases. That has not happened. As companies roll back prices, revenues continue to grow.

 

The debate on whether the Fed will continue to cut rates and by how much continues to rage among traders. I am firmly in the camp of no more than a 25-basis point cut when the Fed meets again on Nov. 5, just one day after the general elections. The Fed does not need to cut more than that given the strength of the economy and the rate of decline in inflation. However, there does appear to be a change in what the Fed can control in the interest rate arena.

 

Historically, the Fed controls short-term interest rates by raising or lowering the Fed fund's overnight interest rate. Normally, longer-term rates would follow suit in the same direction. But little is normal in today's debt markets. The public sector bond market (the bond vigilantes) has shown that they control the long end of the curve despite the Fed’s machinations. It explains why longer-term yields have risen ever since the Fed cut rates last month.

 

Long-term bond yields have plateaued after several straight weeks of rising. Bond players believe that the Ten-Year U.S. Treasury bond yielding around 4.09 percent may adequately discount both economic growth and the present state of inflation — at least for now. I say "now" because the election outcome may send yields soaring once again.

 

The long list of tax cuts, spending programs, tariffs, etc. made by both party's candidates would add many trillions of dollars to an already mountainous deficit. The non-partisan Committee for a Responsible Federal Budget estimates that Trump would add $7.5 trillion to the deficit, while Harris would add $3.5 trillion. At the same time, both parties are completely ignoring the $35.6 trillion in debt we owe right now. The U.S. now has a debt-to-GDP ratio of about 100 percent.

 

But while politicians of both persuasions continue to ignore that fact, the bond vigilantes do not, nor will foreign bond buyers. Their next move, whether to buy or sell bonds, will be determined by what happens on Nov. 5. The polls indicate a narrow win by one candidate and a mixed Congress.

 

If so, neither party will have enough votes to pass legislation that could add trillions of new dollars to the U.S. debt load. A sweep by either party, however, would change that equation and likely set off another spike in long-term interest rates. That, I believe, would be problematic for the stock market in 2025.

 

In the meantime, while the polls have both candidates at a dead heat, traders are taking their lead from the $2 billion presidential betting market. The Street believes the odds carry more weight since players are willing to bet their money on the outcome.  For example, this week, one of the election betting markets (Polymarket) has seen the odds of a Trump win rise to 58 percent-60 percent. Seven other betting markets show an average of 56.1 percent for Trump versus 43 percent for Harris. As such, many in the stock market are convinced that Trump will win.

 

Traders have responded by bidding up areas of the market that they think would do better under Trump. Inflation would be higher, say traders, so hard assets and precious metal stocks gained ground. Bitcoin and other cryptocurrencies climbed since Trump promised to make America a world leader in crypto. Small-cap stocks that are sensitive to lower interest rates, outperformed as well. Here, the idea is that Trump would likely pressure the Fed to keep reducing interest rates. That would also be good for financial stocks.

 

Balderdash, say I. At the racetrack, betting on the favored horse to win does not guarantee the winner. In the days ahead, one or the other candidate may say something stupid, or make a perceived breakthrough that changes the betting odds or the polls. If so, markets or sectors could reverse on a dime. Don't get sucked into playing that game.

 

On Wall Street, volatility is usually interpreted as meaning selling pressure, but that is not always the case. While markets are stretched, overextended, and expensive, they can remain so for longer than one would expect. One contrarian indicator I watch indicates that bullish sentiment among investors is at the highest level of the year.

 

In this environment, we could see sharp spikes higher as well as dramatic declines lower. Depending upon the election outcomes, the downside range could be as much as 5-7 percent. If the election outcome is called into question, the decline could be steeper. What to do? Nothing. Sit on your hands and watch but if the market falls, I would buy the dip.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.