Managing volatility around the US election

Introduction: Preparing for market uncertainty

The US elections are a significant event that can lead to increased market volatility. Political uncertainty, potential policy changes, and market reactions can create both risks and opportunities for investors. While you can’t control market volatility, you can manage your portfolio’s exposure to it. With the 2024 election approaching, it's crucial to have a plan to navigate these turbulent waters.

Markets often react to the perceived winners and losers of an election. For example, policies favoring certain sectors—like green energy under Democrats or deregulation under Republicans—can lead to significant swings in those areas. Understanding these dynamics can help in shaping your portfolio to better handle election-driven uncertainty.

Understanding election scenarios and their impact

The outcome of the US election can influence market sentiment and volatility in various ways. Each scenario presents unique challenges and opportunities for investors. By understanding these potential outcomes, you can better prepare your portfolio to navigate the post-election landscape. It’s important to note that election outcome odds are extremely uncertain ahead of the election. Betting sites have often had exactly 50-50 odds for the two candidates in the weeks leading up to the election. This means that market participants may react quite strongly to specific outcomes, especially if whoever becomes president has both houses of Congress on his or her side.

But first, let’s very briefly review the possible scenarios, with odds from the betting site polymarket.com as of September 30 provided for perspective. Odds should be seen as relative because they add up to more than 100% in aggregate

Scenario 1: Harris gridlock (Odds: 35% for Harris but Dems losing Senate and/or House)
If Vice President Harris wins the presidency but faces a divided Congress, legislative stagnation is likely. This could delay or dilute key policy initiatives, creating uncertainty, especially in sectors like healthcare and technology. Market reaction may be subdued initially, but ongoing gridlock could lead to increased volatility as investors reassess policy impacts.

Scenario 2: Trump gridlock (Odds: 18% for Trump winning but GOP losing Senate and/or House)
A return of Trump with a divided Congress could lead to more unpredictable policy shifts, potentially causing pronounced market swings. Trump’s ability to impose tariffs by executive order without Congressional support could create heightened volatility, particularly in the industrial and financial sectors. Investors should be prepared for rapid shifts in sentiment based on policy announcements and executive actions.

Scenario 3: Democratic Sweep (Odds: 21% for Harris winning and Dems taking both houses of Congress)
A decisive win for Harris would likely be market negative. Her promise to raise capital gains and especially corporate taxes could see a very sharp reaction to the downside. It would also prove inflationary as she would continue Biden’s huge fiscal packages and could new ones, driving inflation and keeping US rates and nominal growth at a higher level than otherwise.. Some sectors like green energy might benefit from fiscal support.

Scenario 4: Republican sweep (Odds: 29% for Trump winning and GOP taking both houses of Congress)
A decisive win for Trump would like generate a quick rally, especially for financial companies and traditional energy companies due to Trump’s stance against regulation and in favour of fossil fuels. But then uncertainty could immediate settle in. Yes, a Republican sweep is positive for sentiment on the anticipation of deregulation and new tax cuts for companies, but there will also be considerable worry and “headline anxiety” linked to Trump’s threat to impose tariffs and the risks this brings. Long bond yields could also rise quickly on the anticipation of more inflation, which could temper stock gains.

Scenario 5: A contested election
A prolonged and contested election result, as seen in 2020, would likely increase volatility, especially if some form of constitutional crisis materializes. Neither side may want to concede this election if it is exceptionally close (which would likely mean that even if Trump won, he will do so while losing the popular vote. Continued uncertainty can dampen investor confidence and lead to erratic market movements. In such a scenario, expect the VIX (Volatility Index) to spike as uncertainty drags on, affecting sectors with high beta and those sensitive to political developments.

Using the VIX to gauge market sentiment

The VIX, or Volatility Index, measures market expectations of future volatility based on options pricing for the S&P 500 index. Often called the "fear gauge," it tends to rise during periods of market uncertainty or stress, such as elections. A rising VIX indicates heightened anxiety among investors, suggesting that caution is warranted. It can be useful for timing protective strategies:

1. High VIX: When the VIX is elevated, options are more expensive. Consider selling options (e.g., covered calls) to take advantage of high premiums.
2. Low VIX: When the VIX is low, options are cheaper. This might be a good time to buy protective puts to hedge against unexpected downturns.

Using the VIX as a barometer helps gauge when to implement different strategies based on market sentiment and expectations of future volatility.

Managing portfolio volatility: Core strategies

Given the potential for market swings, it’s important to focus on strategies that manage your portfolio’s volatility rather than trying to predict market movements. Here are some approaches:

1. Partially going to cash

Reducing market exposure by moving some investments to cash can be a conservative way to reduce portfolio volatility. This helps preserve capital but also means missing out on any post-election rally.

• Pros: Lowers exposure to unexpected market shifts; preserves capital for redeployment if the market reacts poorly to the outcome.
• Cons: Misses potential gains if markets rise sharply.

2. Diversifying across asset classes

Spreading investments across different asset classes such as bonds, commodities, and international equities can help manage portfolio volatility. Different assets may react differently to election outcomes, potentially smoothing overall portfolio performance.

• Pros: Reduces risk concentration in any single asset class; potentially benefits from less election-sensitive investments.
• Cons: Diversification may not fully protect against systemic risks; requires more complex management.

3. Focusing on defensive sectors

Investing in traditionally defensive sectors like utilities, consumer staples, and healthcare can provide more stable returns during uncertain times. These sectors often experience less volatility compared to others like technology or financials, which may be more directly impacted by policy changes.

• Pros: Lower volatility and more stable dividends; less sensitivity to economic cycles.
• Cons: May underperform during market rallies; limited growth potential compared to high-growth sectors.

Using options to navigate portfolio volatility

Options can be effective tools for managing your portfolio’s volatility during turbulent times. They offer flexibility and defined risk/reward profiles, making them suitable for various market scenarios. For instance, you can use options to protect your portfolio against sharp declines or to generate income in a range-bound market.

1. Selling covered calls

This strategy involves holding a stock and selling a call option against it. It can generate income in a flat or slightly bullish market, helping to offset some of the downside risk in the stock’s value.

• Pros: Generates additional income; reduces effective cost basis.
• Cons: Limits upside potential if the stock rises significantly; requires stock ownership.

2. Implementing collars

A collar strategy involves holding the underlying stock, selling a call, and buying a put. It provides protection against significant losses while allowing for some upside potential, making it ideal for conservative, or at least anxious investors that don’t want to simply sell a stock holding.

• Pros: Balances cost with downside protection; offers peace of mind.
• Cons: Caps potential gains due to the short call position; may incur costs for buying that downside protection.

3. Buying puts for downside protection

Buying put options is a straightforward way to hedge against a market decline. This strategy can be particularly useful if you are concerned about sharp market movements or sector-specific downturns due to election outcomes.

• Pros: Direct protection against portfolio losses; predefined risk.
• Cons: High costs in volatile markets; timing needs to be precise; can erode profits if the market does not decline.

Tailoring strategies to investor profiles

Different investors have varying risk tolerances and goals. Here’s how to tailor strategies to your profile:

Conservative investors should focus on cash positions, defensive sectors, or using collars to limit downside risk. Avoid speculative trades and high-risk options strategies. Using cash reserves for strategic reinvestment after election outcomes are clearer can also be effective.

Moderately cautious investors can combine moves to diversify their portfolio with options strategies like covered calls or protective puts. This balanced approach allows participation in market movements while managing downside risk. Consider using short-term options strategies to navigate immediate volatility around the election period.

Aggressive investors may use more directional options strategies, like buying calls or puts on volatile sectors or on the broader market. Consider selling strategies, such as iron condors or credit spreads, if expecting a range-bound market. This approach requires active management and a higher risk tolerance.

Conclusion: Control what you can

The US election is a complex event with numerous market implications. While you can't control market volatility, you can control your portfolio’s exposure to it. By focusing on strategies that align with your risk tolerance and financial goals, you can better navigate this period of heightened uncertainty. Stay informed, remain flexible, and be prepared to adapt your strategy as the election dynamics evolve.