How Much Does Overwhelming Consensus Matter? – Trading the US Presidential Election

With one month left to go, the US presidential election has investors and traders hanging on the edge of their seat. Yet, despite the uncertainty, there is wide-spread consensus about the most probable future path for stocks and a majority of traders anticipate a weak September to October period, followed by a rally into year end.
Does overwhelming consensus lead to lower chances for the event to occur? Or will a positive feedback loop make it more likely for a powerful year-end rally to play out in 2024?

Expected stock market crashes don’t happen
For negative market events it is readily observable that highly anticipated market crashes hardly ever happen, because increased hedging via put options reflexively reduces crash risks. The initial spurt in hedging demand often leads to a front-running effect as a potentially negative period gets priced in in advance. I think, this is exactly what happened with the first part of this year’s consensus expectation: A historically weak September was pulled forward into a volatile correction in August, while the very weakest period of the year showed resilient strength with only moderate downside at the start of the month.

However, I have a convincing hypothesis that the coming period of strength does not follow the same rules. Negatively and positively anticipated timespans do not behave like mirror images, especially because the US presidential election currently creates a wall of worry that will be resolved at a known date.

Year-end seasonality in election years

Many investors pooh-pooh seasonal outlooks, because they seem to be based on unsubstantiated, soft data, but are they really? No, seasonal patterns in stock market returns are not magical constructs merely based on emotional factors (e.g. Santa Claus brings a rally, because it’s such a feel-good time of the year). Rather there are some real and strong underlying reasons that are rooted in the structure of supply and demand flows in the market.
Listen here to a podcast featuring Cem Karsan for a masterclass on the subject.

Re-investment of gains
A root cause for a binary outcome for fourth quarter stock returns is the growing value of assets tied to the stock market during the course of the year. A vast sum of money invested in stocks and diverse financial products primarily based on the S&P 500 has grown by roughly 20% this year. Because the financial system is based on leverage, this increase in the pool of money is deployed back into the market at regular intervals (e.g. monthly, quarterly or yearly) to keep the level of leverage constant – a flow of liquidity cumulating in early January, when diverse re-balancing schedules coincide, is the result.

Should the S&P 500 fall into negative territory over the next weeks instead, funds will be drained from the market likely causing equities to fall further, as, for example, during the 2018 downward spiral.

Momentum has structural causes and fourth quarters tend to either show high-probability, solid gains or low-probability, outsized losses in a binary outcome. Currently momentum is extraordinarily positive, as the market study below shows.

The *momentum factor*, in various forms, is one of the strongest and most reliable market anomalies,
and many of the most successful investment and trading strategies are built on it. SentimenTrader

US Elections
Investors do not hedge for upside risk in the same way as they seek protection from market crashes. Quite the contrary, large institutions and family offices aim for a high degree of certainty before putting new money to work. The election date functions like a damn of uncertainty holding back fresh investments, which resolves at a known date to release a flood of liquidity – regardless of the election outcome.

Options flows
This is exacerbated by distinctly elevated event volatility around the election period. Uncertainty is high, causing strong demand for protection, which in return is hedged mechanically by options dealers. Rising volatility in October is the result. These large, expensive hedging positions counter front-running attempts of the expected year-end rally, because they put pressure on the market as they are opened. Once the election has passed (often starting in the weeks before, as potential outcomes become clearer and clearer) volatility compresses, a major need to hedge disappears, and options become less expensive. This causes another constant tailwind for stocks due to the buybacks released by a reduction in dealer hedging, which lasts all the way to the largest options expirations of the year in mid-December and January.

This is the mechanism behind it: Investors buy put options, primarily on the S&P 500, to hedge. Dealers are short those puts and hedge their own positions mechanically by shorting S&P futures, because they do not bet on market direction. As those put options lose value, dealers must buy S&P futures.

In fact, there is no such thing as an adverse election outcome from the stock market’s point of view, unless civil war breaks out over a contested election .

Because this happens during a period of greatly reduced volume-weighted time, the fourth quarter sees the strongest options-based flows of the year even without a starting point of elevated volatility. Thanksgiving, Christmas, New Year, and other holidays lead to prolonged stretches of time during which financial markets lie essentially dormant. All the natural buybacks from diminishing market maker hedging requirements (Vanna and Charm effects cause options to fall in value as uneventful time passes) flow back into the system concentrated in a shortened active market period.

To a large degree these structural flows happen in any case. They are independent of investors’ consensus expectations, election results, or most other factors. As a result the coming fourth quarter has a strong bias for positive returns at a 80%+ probability, but this comes in concert with a low-probability, fat left tail: Should a meaningful decline of more than 15-20% occur over the next weeks, many of these effects reverse and could lead to a self-reinforcing downward spiral.