Election Day Commentary

The market is in something of a holding pattern as this is election day, 2010.  The expectations are, of course, for a Republican victory to reclaim the House, and now there is even a reasonable chance that they take the Senate, too.  The market views this news as very positive.  Not to throw cold water on the never-ending party, but it should be noted that the first Republican gains against President Roosevelt came in the mid-term elections of 1938 (the Democrats did not lose seats during the first Roosevelt mid-term election in 1934).  For those who have studied our analyses of the 1937-1939 (and later), it should be noted that the stock market rallied strongly in 1938 on the day after that Republican victory and then never traded at that price or higher again for seven years!! 

The next “event” on the horizon is tomorrow’s FOMC meeting and announcement.  Many are expecting to hear that that QE2 (the second round of quantitative easing) has begun.  Again, far be it from me to make a reasonable observation in the face of overwhelming bullishness, but if the Republicans take control, isn’t there a strong chance that they will try to stop government spending?  And what better place to start than with QE2?  Oh well, the bulls must have thought of that, haven’t they?  I guess they, like most of the political pundits too, are completely discounting the Tea Party’s mantra that they want a “restraining order” in place.  The stock market is acting like it’s the old, Bush Republicans who will occupy these seats.  I do not think that’s the case at all.

The third event – Friday’s jobs report – is a total coin-flip, but it could cause a market reaction either way when announced.
These events have been keeping near-term option prices elevated, which is why $VIX is still hanging around at levels above 21, even though VIX futures have steadily been decreasing.  That is, there are finally some sellers of longer-term $SPX puts (and other options), and that is reflected in the $VIX futures prices.  The November futures are trading at a discount, and the Dec futures have a premium of “only” 2.54.  The longer-term futures are still rather inflated, with premiums above 6 points, so the term structure continues to slope steeply upward.  This has been going on so long that some might think it’s become a permanent thing, but it hasn’t.  Eventually the term structure will flatten – when there is a correction of some meaningful amount or duration. 

Actual $SPX volatility has dropped to 11% for the 20-day historical.  In fact, this broad market rally from early September has been another very “tight” one – that is, volatility is low, and there are few if any fluctuations away from the rising trend line.  If you’ll recall, this is very similar to what we saw in February to April of this year.  In fact, by the end of that rally, the market was setting records for “days above the 20-day moving average,” and other acts of levitation rarely seen before.  We know how that ended – with a thud in the May-June correction.  It would certainly be possible for something similar to happen now.
Of course, there is the other side of the coin: our intermediate-term indicators are bullish.  The $SPX chart is rising, and there are levels of support below the current prices.  The weighted equity-only put-call ratio is bullish.  $VIX has not broken its intermediate-term downtrend, so that’s bullish, too.  The most negative of these indicators is breadth, but advances are swamping declines today, so that should shore up the breadth oscillators.  If this sideways movement over the past couple of weeks proves to be the “correction” (for example, breadth oscillators moved from extremely overbought to neutral during that time), then the next upside breakout could be huge.  A close above this resistance in the general area of 1190 would lead to a challenge of April highs at 1220.  A breakout over there, and you’re looking at 1300+. 

The bottom line appears to be this: with implied volatility levels so high above actual volatility levels, we know that is a signal for impending market volatility.  And that’s what we really expect to happen.  Thus straddle buys and the $VIX/SPY hedged strategy are likely to be the better approaches at the current time.

To receive similar analysis on a daily basis, sign up for The Daily Strategist.