Updated: Oct 20, 2020
This is not investing advice. Seek a financial professional before making important financial decisions. This article is for informational purposes and should not be interpreted as a recommendation to buy/sell/or trade any security.
Trading around an election is almost always a bad idea for almost everyone. A big reason for this is the uncertainty around how markets will react to an election...but the even bigger reason is that many have strong political beliefs and associated biases that lead to a failing in seeing reality, and acting on the ever changing market signals and events when the data doesn't support these biases.
That said, there are some important risks and opportunities that we are considering as we get close to the election.
We anticipate a higher than currently expected probability of a contested election. This has led us to creating a short portfolio that is tailored to both a rise in Trump's probability of winning as well as increasing probability that we are headed into a second wave of SARS-CoV-2. We expect to hold this short up until the day before the election, covering before the hedging unwind that we expect to take place the following week. At that point we will likely begin shorting companies that have benefited from the pandemic in ways that we do not believe to be fully persistent as the narrative moves toward the impact of the new administration. The size of this short position will depend on the outcome of the election...with the largest short hedge coinciding with a contented Trump victory.
Our full analysis and subsequent strategy details are outlined below in four parts:
SARS-CoV-2 Second Wave
Probability of a contested Trump victory
Short portfolio heading into the election
Short strategy post election and the new narrative
We address each in turn...
1. SARS-CoV-2 Second Wave
A second wave appears likely to be underway for several reasons...
A rise in case numbers had already begin shortly after back-to-school
Globally deaths and cases are rising.
Nationally cases are rising as are hospitalizations
Trump's remarks and recovery are likely to increase risky behavior
More people will be socializing indoors with the colder weather
Colder weather is also likely to increase the seriousness of any second wave
Positivity rates in the USA never fell below 5% and may have bottomed despite increases in testing.
Google searches for Coronavirus Symptoms and COVID19 Symptoms have increased in recent weeks.
These charts below support this evidence...
For these reasons we reversed course on our COVID19 short which we had been sharing on Twitter the past month. Today's market action supported this decision as these stocks were as a group up about 2-3% compared to the S&P 500 which was down about 0.7%. We plan to re-initiate this short post election as we explain later.
The rise of a second wave is going to be a headwind for the market as a while, but will disproportionately hurt emerging markets, services, hospitality, brick and mortar and fossil fuels. For these reasons we are including some of these companies in our current short going into the election.
2. Probability of a Trump Victory
Market expectations for a Biden victory have increased substantially since early September. FiveThirtyEight is a widely covered forecast based mostly on polling numbers run by Nate Silver which currently has Trump at a 13% chance of victory. Betting markets have Trump's probability at 66.3%.
Stocks have done particularly well since the first presidential debate. Polls post this debate suggest Biden won...which is also supported by his rise in the polls. This appears to be driven by a reduction in the probability of a contested election; which a recent BofA poll of asset managers suggests helped risk assets.
Trump has also refused on several occasions and without contradiction to agree to a peaceful transfer of power should he lose. He has also actively tried to undermine credibility in the upcoming election by calling mail-in-ballots likely to be fraudulent and by asking supporters to stand watch at polls on election day.
For these reason we expect any material increase in Trump's perceived probability of winning the election would be bad for risk assets broadly.
We believe that there is still a higher than expected chance that the election will be contested. The primary drivers of this are as follows:
Trump will likely benefit from having recovered from COVID19 because it plays to his narrative that it is not dangerous.
Pence did a better job than Trump with his base...mitigating some of the damage from Trump's debate performance.
Democrats are more likely to vote mail-in ballots because they recognize the seriousness of the virus and Trump says that mail-in-ballots are full of fraud.
Our expectation is that Trump has perhaps a 40% chance of winning because of the reasons stated above. Importantly...a contested election is even more likely given the high percent of mail-in-ballots and while these ballots per generally legitimate there is more room for Trump to de-legitimize these votes and use his influence over both the Legislative and Judicial branches of government to push through a victory.
3. Short portfolio heading into the election
Stocks tend to have outflows before a big known risk like an election. The psychological reason for this is a generally overweighting of known risks. By over-pricing we mean that known risks are, on average, given a greater weight then they deserve relative to the severity of the known risk. Elections are a great example. Below you can see the average outflows before elections going back to 2004. These outflows are almost immediately followed by inflows...even when the risk event worrying investors occurs, such as Trump's victory in 2016. Our short position is timed to get ahead of this outflow and cover before the inflows.
Our current short position is used to offset our long positions (see Portfolios) and include companies that appear at risk from both a SARS-CoV-2 second wave as well as an increase in the probability of a Trump contested victory. We believe both of these risks combined warrant a short that is large enough to fully hedge our market risk up until the day before the election.
Our current shorts are shared below...subject to change without notice. For the sake of time we are simple pasting a screenshot from Etrade. There is one factual error with this chart and that is the Percent of Portfolio which for reasons unknown to us are not calculated currently. Our short on junk bonds (HYG) is roughly 33% of net-asset-value not 9.11%. However, the relative weights are correct so simply multiply each by roughly 3.7 to get actual weight. Again, these are subject to change without notice.
These shorts largely composed of junk bonds, leveraged loans, Mexico, small cap US equities, renewable energy, and marijuana companies. These shorts were identified based on the criteria below:
Stocks and bonds that are sensitive to a second wave of SARS-CoV-2.
Stocks that benefited recently from the increased probability of a Biden outright victory.
Stocks that have a high RSI.
Your comments on Twitter on this short portfolio are appreciated. We expect the composition of this portfolio to change in coming days as we refine our strategy.
4. Short strategy post election and the new narrative
We expect to close our current short portfolio addressed in the last section the day before the election. The reason is that investors tend to over-price known events and many are still concerned about a contested election. However, post election we plan to re-enter our short SARS-CoV-2 strategy as the election narrative move past the pandemic and into a post election narrative.
We consider four possible scenarios post election...
1) Trump victory 1A) Uncontested (clear victory) 1B) Contested (Congress/Supreme Court) 2) Biden Victory 2A) Uncontested 2B) Contested
We believe that scenario 1B posses the greatest risk to stocks. This is important to use because if this outcome occurs then it will will not change the composition of our new SARS-CoV-2 short strategy, but will have an influence on the size. The size will depend on current market prices and the state of the second wave...but it's likely that scenario 1B would support a full beta hedge as we are doing now as compared to only a 25% hedge under the other three scenarios.
The reason we believe a contested Trump victory would be particularly bad is as follows...
First, by "contested" we mean that Democrats widely view the election as unfair. This may involve Republican Governors holding up mail-in-ballot results. It may involve widely reported instances of Trump supporters harassing voters at the polls. It would almost certainly include an election decided by the Supreme Court. But the most important factor in defining "contested" is that Democrats widely view the election as unfair.
We believe that is Democrats widely view the election as unfair that there will be a substantial uptick in protests. Protests have been mostly peaceful...with around 5% having some element of violence. We believe that initial protests under scenario 1B would remain in roughly this range (below). However...
Trump seems far more likely than Biden to resort to using his control of the military to confront protestors. Those paying attention without political bias are fearful of a Trump re-election because he has shown himself to be erratic, selfish, and willing to make statements and engage in activities that undermine our Democracy.
For these reasons we believe that it is likely that if Trump should win and there are widespread protests there is a good chance he will respond with force. He has shown a willingness to do this already against primarily race driven protests. This during an election year in which he had much to lose in terms of the more moderate electorate. After the election he would no longer have this reason for restraint. This increases the likelihood that Trump would meet violence with more violence leading to an escalation in social unrest.
Your reactions to the above scenarios, underlying assumptions, and our conclusions are appreciated.