This year’s election results could have major implications for equity valuations.
It’s fair to contend that the country has never been as polarized as it is today. This year’s election outcome will have a profound impact on equity valuations—or at least that’s what the market appears to be telling us. While there are alternative or supplementary explanations for the expected uptick in valuation volatility (such as a resurgence in COVID-19 infections), there will undoubtedly be strong impacts on various industries due to the election itself. Election Day has the potential to surprise us in many aspects:
With this year’s referendum likely to result in valuation changes, we turn our attention to the question of how much. Let’s discuss the implied valuation volatility for large-cap US stocks as proxied by the CBOE Volatility Index (VIX®) and its derivatives.
What’s the VIX® again, you ask? Akin to the S&P 500® Index, which is calculated by market-capitalization-weighting the 500 largest publicly traded companies in the US, the VIX® Index is calculated by weighting the expected volatility embedded in the pricing of S&P 500® put and call options. Without going into further detail, we can simply state that the VIX®-squared is equal to the fair value of one-month variance swaps. Thus, the index provides the market’s collective forecast of likely gyrations in US large-cap stocks for the next month.
As of yesterday’s settle of 28.56, the market is undoubtedly implying future volatility, which is substantially larger than that which was realized during Q3 (about 17% annualized). This is, of course, due to the fact that the referenced one-month period includes election results, conclusive or inconclusive. Consequently, an interesting exercise involves the estimation of implied moves assuming that such movement isn’t expected to be regular—rather, confined to a small number of large moves surrounding the election results.
Let’s say that the S&P 500® realizes volatility equal to that realized during Q3 (approximately 1.1% per day) on days that are subjectively not impacted by election results. We then back into the magnitude required to realize 28.56% volatility assuming such movement is limited to a particular quantity of days.
What could the VIX® be implying?
For illustrative purposes only. Parametric does not warrant any particular market movement or corresponding VIX®level..
What’s even more interesting is that we can derive predicted levels of the VIX® from the VIX® futures market. Whereas yesterday’s VIX® settlement is known as the spot price, one-month VIX® futures with a “delivery” date of November 18 settled at 29.30%. Notice that the November 18 level is higher than yesterday’s 28.56% level that references options that contain today through November 20 (inclusive of the election). In contrast, the November 18 VIX® references options that only contain November 18 to December 15 (exclusive of the election). So, what gives?
Market practitioners are generally attributing this contango (a future price greater than today’s price) to the possibility of a lengthy and turbulent election process. Here’s an analogy: whereas publicly traded equities typically have a known earnings announcement date, this “United States earnings event” has an unexpected earnings announcement date. Moreover, it’s impossible to know in advance whether the earnings will be readily available at one instant in time or slowly dripped in a piecemeal fashion, potentially jolting markets up or down as the information becomes digested.