Senin, 05 November 2012

The election could be a positive surprise for the market

I'm a fiscal conservative and a supply sider, so naturally I think that a Romney win in tomorrow's elections would be better than an Obama win. Romney would most likely steer the economy in a direction that would reduce the size and influence of government (thus increasing individual liberty) and increase the after-tax rewards to work, investment and risk-taking (thus boosting growth). Obama, as he has demonstrated in the past four years, would work hard to do just the opposite. A Romney victory would improve the outlook for the economy, whereas an Obama victory would just mean more of the same disappointing growth that we've seen in recent years.

Yet when I look at the market, I see no sign that the market is enthusiastic about the election results. Perhaps this is because the intrade odds say that Obama has a 67% of winning. Perhaps it's because the polls are inconclusive, and some polls show that Obama has a good chance of winning. Perhaps it's because the market for a long time has been reluctant to believe that things will get better. For whatever reason, I don't see signs of optimism, so I must conclude that the market is braced for an Obama victory.

So if Romney wins tomorrow, that could end up being a very positive surprise for the market.

Let's review the key market indicators that reflect the market's view on tomorrow's election results.

This chart of the implied volatility of equity options (the VIX index) tells us that the market is not nearly as nervous or fearful on the eve of a major presidential election as it has been at the depths of the Great Recession and the flareups of Eurozone sovereign debt default angst. At 18.3 today, the Vix is above the levels that are associated with periods of relative tranquility (10-15), but orders of magnitude lower than the levels that have been associated with crises (30-100. The market is concerned, but not terrified; worried, but not extremely so. Could this be complacency? I'm not sure. But it's not a sign of a market expecting a big positive surprise tomorrow. It's a market braced for more bad news, of the same variety we've had.

2-yr swap spreads are excellent indicators of systemic risk as well as excellent predictors of the financial and economic health of the economy. Today, swap spreads are about as low as they have ever been, and this is a good sign that the economic and financial fundamentals are healthy. Financial markets have no lack of liquidity; people can exchange risk with almost no friction. Nobody is locked into uncomfortable positions for lack of liquidity; those who were uncomfortable with the risk they were bearing have had ample opportunity to get out of their positions.

As the second chart shows, all of the above applies also to the Eurozone. There are still lingering problems, to be sure, but Eurozone swap spreads are low enough to be considered reasonably healthy. There's nothing fundamentally wrong with the economy, the problem is that the market doesn't see any reason to believe that things will get better.

Consistent with my view that this has been a reluctant recovery, the equity market continues to believe that earnings will decline, and perhaps significantly. There's more pessimism out there than optimism. That's why PE ratios are below average, even though corporate earnings are close to all-time highs both nominally and relative to GDP. The market is braced for bad news.

10-yr Treasury yields are almost as low as they have ever been. It's not because inflation is extremely low—it's because growth expectations are extremely weak. Inflation expectations are at the high end of their historical range, to judge from the spread between TIPS and Treasury yields. But with most TIPS real yields trading in negative territory, the only conclusion to be drawn here is that expectations for real growth are dismal.

Credit Default Swap spreads are roughly unchanged over the past few years, but they are still substantially higher than they were prior to the onset of the Great Recession. As with the VIX index, this is a sign of a market that is concerned, but not terrified. It's consistent with a market that is braced for more of the same disappointing news: weak growth, high deficits, Congressional gridlock, you name it.

When the market is braced for bad news, all an investor needs to win is for the news to be a little better than bad. If we indeed get a Romney win tomorrow, the news could eventually be much better than bad, and that's what leaves me optimistic.

(One major caveat: Romney's position on China is dreadfully wrong. I can only hope that he is shamelessly pandering in order to win over some independents, and that when he is actually in charge he will, as Obama has done, conclude that engaging in a trade war with China is in no one's interest.)

Who do I think will win? Romney, by a comfortable margin. I think the polls are systematically overestimating Democratic turnout, and underestimating Republican turnout. Thus they are underestimating Romney's strength by enough to put him comfortably over the top. I like Peggy Noonan's most recent take, "Monday Morning."

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