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:
- A contested vote. This could drive a massive downside for the equity markets as it did during the 2000 election—until the Supreme Court’s ruling.
- Taxes. Biden’s tax proposal could cost as much as 12% of the S&P 500® earning, but deficit reaction could offset longer-term growth according to sources in the industry.
- Regulations. Surprisingly, there are no historical relationships between returns or multiples and the quantity of regulations levied against corporations.
- Industrials. Though it’s perceived that tighter regulations under Biden would impair industrials, an infrastructure bill would offset a Democratic sweep.
- Defense. A Trump victory and a split Congress would likely result in more defense modernization, while a Democratic sweep could result in a large military reduction.
- Health care. As long as Congress remains split, a Biden win would not necessarily have an impact on the industry, for better or worse depending on sub-sectors.
- Banks. Analysts don’t predict any major regulatory changes.
- Internet. A Biden victory is perceived as positive for internet stocks.
- Gaming. Trade issues could extend beyond import or export goods to services like gaming, with Macau gaming concessions expecting to be renewed in 2022.
- Home builders. A potential repeal of the deduction gap for state and local taxes could boost demand—particularly in the high-tax coastal states.
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.