As S&P 500 hits a record, investors warn there's likely turbulence ahead tied to the election

Published Wed, Aug 19 20207:05 AM EDTUpdated Wed, Aug 19 202010:28 AM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

The S & P 500 is heading toward Labor Day at an all-time high, but investors are warning of turbulence tied to the election. Some pros are already starting to hedge for a drop leading up to and after Election Day. Typically, Labor Day is the time when the markets begin to take presidential polls more seriously. It also comes after each party's convention, and the candidates will have helped themselves, or not, with their performances. What's different this year is investors are looking for protection that goes beyond the vote because of the concern that there will be no clear winner after the polls close and there could be a long period where it is contested. "If you look at the back and forth between the two political parties, it's entirely clear that there may be a period of time after Nov. 3 where we really don't have clarity as to who is going to be the occupant of the White House on Jan. 20, and that is new," said Julian Emanuel, BTIG head of equities and derivatives strategy. "While we continue to see hedging out over the election, we've had more conversations with clients in the past week or so, as polls have tightened ... about hedging out to either the end of January or the February expiration cycle which captures Jan. 20." For months now, investors have been hedging more than usual because of the election, betting it could result in a big sell-off and high volatility. Even in the spring, investors were running up the price of S & P 500 put options , making negative bets on the market for November and December. Emanuel said there's not a large amount of activity now in the S & P options. "It's more like an adjustment in pricing to reflect the fact that in the last couple of weeks there's been heightened uncertainty," he said. President Donald Trump has suggested the election should be postponed , and he has opposed mail-in ballots, expected to be used by many voters because of the risks of the coronavirus. Trump cannot delay the election under the Constitution, and a cross section of congressional leaders have said it would not be delayed. The post office has warned states that it won't be able to guarantee that it can deliver the ballots in a timely manner. Democrats in Congress are investigating cutbacks by the Postal Service. "We're at an inflection point. The data could be pretty volatile over the next couple of weeks," said Dan Clifton, head of policy at Strategas Research. "Typically, campaigns get bounces out of their conventions. ... The average polling bounce has been 5 percentage points since 1964, but in the last few it's been smaller." Democrats losing momentum? Joe Biden, now in the middle of the Democratic convention, has lost some ground in the polls and is up by 7.7 points after leading by 10 in early summer, according to the average poll on RealClearPolitics.com. The wider the polls, the more uncertainty in the market. The market already has plenty of cause for concern, even as it trades at highs. There is worry the coronavirus could return in the fall as schools reopen, and that the economy will have a hard time recovering. There is also concern tensions with China will continue to rise into and after the election. "I'm anticipating some volatility over the next couple of weeks about how investors have been viewing the election," Clifton said. "Now you're going to start getting some events that could move the needle in either direction. The big change in the last three weeks is the market is starting to fade the idea that the Democrats can take the Senate." He said the gap is closing in some battleground states and it looks like just the Senate could fall 50-50 between Republicans and Democrats, as of now. Emanuel said investors have been hedging in S & P 500 options around potential uncertainty and volatility in November and December for awhile, and out-of-the-money puts on the S & P 500 have gotten expensive. Investors are also now hedging out to January and early February. Jan. 20 is Inauguration Day. "There's definitely a dose of fear. ... What we've been advising clients is if you want to hedge, you're better off hedging out to September and October because it is much cheaper and it may be that the market is going to discount at some point, the election uncertainty, particularly given the history of September being the worst month of the year historically," he said. Some strategists have said the market is more fearful of a Democratic sweep, so it could be more relieved if Biden falls back in the polls. His tax policy is viewed as a negative by investors, and he has made it clear he will raise taxes on corporations. October storm? Dan Deming, managing director at KKM Financial, said activity has been heaviest around VIX options for October, with investors betting there will be increased volatility ahead of the election. The VIX is the Cboe volatiliti Index. Based on puts and calls in the S & P 500 , it is used by investors to bet on volatility or as a hedge. Known as a fear index, the VIX closed at $21.51, up 0.8% Tuesday "We're still seeing a lot of demand for volatility exposure around the election. There is a fair amount taking place. You're seeing it heavily skewed toward that last couple of weeks of October," Deming said. The October VIX futures contract was priced at a premium of $28.80 as of late Tuesday, but November was slightly lower at $28.25. December is priced at $27.45 and January at $27.70, the same as February. "As we're moving to the conventions it most likely will shift, depending on how the market views the potential outcome," he said. The Republican convention is next week. Deming said an investor last week made a big bet in VIX options that there could be some high volatility early next year that could send the VIX to the highs it saw during the market panic in February, when it surged above 80. The trade was for more than 25,000 January call options with a 75 strike. "It was a 75/150 call spread. They're buying way out-of-the-money call spreads to either hedge some downside risk or playing for a big move higher in the VIX," Deming said. "If it happens earlier, that call spread would appreciate in value quite a bit." Matt Maley, equity strategist at Miller Taback, said he expects to see more hedging activity after Labor Day, particularly if the market continues to trade at highs. The S & P 500 erased its coronavirus losses and closed at a new all-time high of 3,389 on Tuesday. It also set a new intraday high of 3,395. "It's really going to depend on the market," he said. "If it holds up, they definitely have to put on some more hedges. There's a number of ways to do it of course. If the market holds up, the VIX is going to come down and it becomes cheaper to buy protection in the options market." Maley said that in 10 out of 12 presidential election years since 1972, the market moved higher by an average 7.3% between the election and year-end. But in 2000, the year George W. Bush was elected after a challenge by Al Gore, the market fell 7.5% amid the uncertainty. There was only one other negative year, when the S & P fell 1.8% between the election and year-end. "If the mail is an issue, it's not just going to be the presidential election that's uncertain, it could be quite a few House seats and some Senate seats as well," said Maley. UBS strategists said investors should be prepared for volatility in the event of an inconclusive result, but they don't expect it to be long-lived. "Markets abhor uncertainty, so it is reasonable to expect safe havens such as gold and US government securities to offer some refuge," they wrote. "However, it is too early to adjust portfolios in expectation of a close contest in battleground states. And it is also worth noting that any initial volatility should dissipate over time."

Traders wearing masks work, on the first day of in person trading since the closure during the outbreak of the coronavirus disease (COVID-19) on the floor at the New York Stock Exchange (NYSE) in New York, U.S., May 26, 2020.

Brendan McDermid | Reuters

Typically, Labor Day is the time when the markets begin to take presidential polls more seriously. It also comes after each party's convention, and the candidates will have helped themselves, or not, with their performances.

What's different this year is investors are looking for protection that goes beyond the vote because of the concern that there will be no clear winner after the polls close and there could be a long period where it is contested.