This is what could happen to the stock market if Donald Trump wins

Wall Street's long-running view that Hillary Clinton would easily become the next president has been replaced by a new fear that Donald Trump could win, and it probably won't be a pretty picture for stocks if he does.

Bond yields have moved lower and so have stocks, as the markets have begun to react to the possibility of a Trump victory in the last several days. On Thursday, the S&P 500 was up slightly, after falling 13 points Wednesday, to close at the key support level of 2,097.

The work of two economics professors may provide a glimpse of how the stock market might react if Donald Trump were elected. They studied the predictions market, including PredictIt.org and the reaction in the financial markets to events around the election. One of the economists says their findings point to a sharp immediate sell-off if Trump wins and a slight rally if Clinton wins. The amount of the rally or sell-off depends on the predicted outcome.

Donald Trump
Carlo Allegri | Reuters
Donald Trump

"If we were to go in 70/30 [for Clinton], and we think the market is 10 percent higher under Clinton than Trump, if Clinton wins it should be up about 3 percent and if Trump wins, it should go down 7 percent," said Eric Zitzewitz, economics professor at Dartmouth College. He and Justin Wolfers of the University of Michigan studied the market effect of the first debate in a Brookings paper. Clinton's odds in the prediction markets had been closer to 80 percent, and at that level, a Trump victory would have triggered an 8 to 10 percent sell-off, he said.

The market's nervousness picked up after the FBI last Friday revealed a new investigation into Clinton's email server, this time involving her longtime aide Huma Abedin and her husband Anthony Weiner, who is under federal investigation in a different matter.

"There's no question in my mind that the markets have not priced in a Trump win, only in the most cursory way. They are starting to price in the potential for a Trump win. That process started last Friday," said Tony Roth, CIO of Wilmington Trust. "We haven't seen an up day in the markets since then. We haven't seen any calamitous days either."

Strategists agree there would be a sell-off with a Trump win, but then the views diverge on how the market would trade after that.

Ethan Harris, head of global economics at Bank of America Merrill Lynch, said he would expect a sell-off if Trump wins, then an L-shaped move in the equity market, because of the period of policy uncertainty. "From the action in the stock market, the equity market is worried about a Trump victory, about the uncertainty of policy under Trump. Normally the equity market responds positively to a Republican doing well in the election," he said. "In this election, I think the dominant story is about uncertainty after the election, and a status quo election means no shock, everything is the same, no big news and presumably the equity market sails through the election if it's a split government."

Markets had been looking for a win by Clinton but also Republicans holding the House and possibly Senate. The idea is that that would create gridlock and many of her policies could not be enacted.

"Under a Trump victory, you probably get some kind of reaction in the equity market, and if it's a strong reaction, it could affect the Fed," he said. Harris said he would expect to modestly lower his GDP forecast if Trump wins. "To a large degree, we're going to look at the market's response as a gauge of the underlying uncertainty shock," Harris said.

Bruce Bittles, chief investment strategist at Baird, has a different view and he believes a Trump victory could result in a V-shaped move in the market, as Wall Street reflects later on positive tax changes and the looser regulatory environment Trump supports.

"What I think happens is we get a repeat of what happened after Brexit. The market initially goes down and then goes up," he said. He said with a Clinton win, the market would rally but not as much as it historically has when an incumbent party wins. "It depends now on how a Democratic win is already built into the market. If that's the case, then I would say a Republican win would mean a sharper down, but then a sharper up to follow," Bittles said.

Roth said if the odds of a Clinton victory continue to move lower, so will the stock market. "If Clinton wins, you get a big relief rally. If Trump wins, then you get a big sell-off. I think that from where we are today, until the bottom of that sell-off, you are looking at a good 10 percent easily. I think whether it goes deeper than that depends on the temperament that Trump displays after the election," Roth said. "I think Clinton will have the upper hand from an electoral position, but it's not going to be like a 75/25, it could be 60/40 [chance], and the more it converges, the more the sell-off … the closer this gets, the more steep the sell-off is going to be."

PredictIt.org put the odds for a Clinton win at 66 percent Thursday, down from a high of 85 percent Oct. 25. The odds had been as low as 60 percent in September.

Zitzewitz said he studied the reaction of markets when a tape was revealed in which Trump made lewd comments about women, and also the reaction Friday when the FBI news broke. The market moves confirmed the study he did after the first debate of the prediction market and financial markets. He said if the odds shifted in the prediction market to 60 percent for Clinton, a Trump victory could mean a 6 percent sell-off in the S&P futures the night the results are released. He said his study did not go into what would happen after the initial reaction, and it would react to other events like the concession speech and other developments.

Roth said he expects the market to remain choppy and possibly sell off through Election Day, Tuesday. "The Trump chances of winning is not one out of 100. It's probably three out of 10 and likely to move higher … that could cause a real panic in markets," he said. Roth said markets could remain under pressure if Trump wins, especially if does not surround himself with credible advisors.

Trump could also take action against U.S. trade partners, declaring them in violation of trade agreements, and that would upset markets, especially since there could be retaliatory action, Roth said. He said that could cause a downward spiral in trade, which could hurt weaker economies.

"If we have a Clinton outcome, we're pretty constructive on the outlook for the global economy. We think we're in the final chapter of monetary insanity," he said. He said easing by global central banks was necessary but now it's no longer effective and a move away from it would be positive.