The Only Thing We Have to Fear…

The market rebounded sharply this week to finish with impressive gains across all major indices. The best performing of the US stock indices was the Russell 2000. The small cap index’s gain of 6.42% for the week help narrow some of the large performance disparity between it and the Nasdaq 100, which has been expanding over the last 12 months. The small cap index outperformed both the large cap S&P 500 and the tech-heavy Nasdaq 100 index by 2.6% and 2.3% respectively. Despite the fact that there has been both hints and rebuffs surrounding the size and timing of the next stimulus bill.

A number of people I have spoken to have expressed concerns about the upcoming election and the impact it could have on the stock market. My feeling is that the market now is pricing in the probable outcome of a blue sweep. While some have expressed concern about the potential for increased regulations should the Democrats control both houses of Congress and the Presidency, it is important to note that the stock market currently has one primary focus more and more stimulus. Whether the stimulus comes from the Fed or Congress, the market has a Pavlovian response to stimulus fuel. Should one party control the legislative and executive branches the pump will be primed for more cash infusion into the economy and the market.

I like to say that the market is forward looking, but extremely nearsighted. With an almost addict-like behavior the stock market seems perpetually focused on its next fix. The consequences of greater and greater deficits seem so far down the road, in the market’s eyes, that only the immediacy of the stimulus seems to matter. But certainly, if we think this through, don’t all actions have consequences? There is no such thing as a free lunch, the saying goes. Deficits can and do lead to inflation. Inflation can and does lead to higher interest rates and currency debasement. These beliefs seem, on the one hand, basic Econ 101. But on the other hand, some would have us believe that this type of economic reasoning is an antiquated school of thought. I am not one of these people, however.

I subscribe to the belief that what comes around eventually goes around. If printing money and handing it out doesn’t have negative consequences, then why would we ever not do it? In fact, why would we ever limit it? To a degree, ironically, this idea has essentially become modus operandi in Washington, since up until now all stimulus efforts have had no impact on interest rates and has only led to inflation of financial assets. However, we need to keep in mind that one benefit we have in the US is the fundamental role the US dollar plays internationally. As the reserve currency for international commerce, the US dollar is the closest thing the world has to the gold standard. Reserve currency status insures a steady demand for dollars and, by proxy, for obligation notes such as short term treasury bills. In short, it helps keep our interest rates low and our access to credit open. It is the closest thing to a free lunch that we can get. Not surprisingly the USD’s reserve currency status is the envy of the rest of the developed nations.

If we were to lose that role it could have potentially devastating consequences for the US economy and financial markets. Should Washington continue to overlook this potential and flood the market with Greenbacks, what is now just chatter about replacing the dollar as the reserve currency could eventually form into plans and plans which could become actions. For the time being, this remains a distant concern and the gravy train continues to run. Like I said the market is forward looking but extremely nearsighted.

For now, the market has priced out much of the concern it had just a month ago with regards to the election. One month ago, the volatility for November expiration options relative to the October and December options was the highest on record for one month relative to its surrounding months. This was sending a signal that the election had a high likelihood for causing market turmoil. Fast forward to today, the November expiration volatility on the S&P 500 index is lower than all the months that follow it. The term structure is back to its more natural state of contango. Contango is when the further out months trade at higher volatility than the nearer term months. Vix (Cboe Volatility Index) contango implies a condition of calmer future price movement. The overall volatility level still remains elevated, which indicates we are still not out of the woods. But the term structure is indicating that we can begin to see an opening ahead, and that the election may not be as big of a fear factor as previously believed.   

Thanks for reading,

Zach and Dave  

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