Massive divergence between US stocks and the stock market’s “fear gauge” as election looms
Traders are taking out insurance against a market-unfriendly result to the November 5 vote even as stocks continue to climb to fresh records.
The US election is creating a big disconnect between the performance of the S&P 500 and traders’ most popular gauge for assessing the level of worry among market participants: the VIX.
Typically, when the S&P 500 Index has made an all-time high, the VIX Index — the expected volatility of the benchmark gauge over the next 30 days, often called the market’s “fear gauge” — is at 13.5. Last week, the VIX ended above 20 twice while US stocks set fresh records.
Only 12% of S&P 500 record closes saw a higher VIX than Friday’s close. Nearly all of these instances were during the dot-com bubble or the market’s rapid reclamation of all-time highs after the pandemic struck, though mass uncertainty still reigned over when we’d see life return to normal.
The VIX Index is based on one-month options prices. Usually, its expectations are somewhat extrapolative, hinging on recent history. That is, if the market just had a big down day, people will be more concerned about the potential for the beatings to continue until morale improves. Vice versa if there’s been smooth sailing recently.
Currently, the realized volatility of the S&P 500 over the past month is 10.1 — low by historical standards. High implied volatility right now is not based on extrapolative expectations, but rather, it’s effectively a function of traders taking out insurance, as the results of the election might prove unsettling to the stock market.
“Looking out over the next few weeks, however, the vol premium for the US election is likely to keep moving higher as it has in prior elections,” wrote Deutsche Bank strategists led by Parag Thatte.
Of course, it’s notoriously difficult to say what kind of election outcome would cause the most knee-jerk negative response in markets, or when political changes really leave a market imprint. US equity futures dived as the 2016 election results showed a surprising victory for President Donald Trump, only to turn around and scream higher as traders decided that a world of tax cuts wouldn’t be the worst thing for corporate America and could outweigh any potential negatives.
Stocks performed well after the 2020 results. But what really began to kick off volatility in the bond market was the run-off Senate election in early 2021 that gave Democrats full control of both legislative bodies of Congress and made it easier to increase government spending.
Dennis DeBusschere, 22V Research chief market strategist, reckons that a divided government will be the most market-friendly outcome for the November 5 vote.
“An orderly election, no sweep, and continued strong economic growth would reduce tail risk concerns, supporting lower implied vol, a risk-on rotation, and higher markets in the final months of 2024,” he wrote.
On that front, expectations are about as much of a coin flip as for the presidential election itself — at least according to betting markets. On Kalshi, the cumulative probability of a Republican or Democratic sweep is marginally higher than any divided-government result.
And while it’s not the usual state of affairs, we do have some historical precedents for US stocks and implied volatility moving higher in tandem. John Kolovos, chief technical strategist at Macro Risk Advisors, likened the current setup in stocks to the mid-’90s, when Federal Reserve interest-rate cuts helped the economy achieve a soft landing and the S&P 500 and the VIX Index proceeded to trend upward.
“I remember this old saying: you can have a low-vol bull market, you can have a high-vol bull market, but you can never have a low-vol bear market,” he said.
