Right on the election, dead wrong on the market reaction
Three possible reasons for why stocks soared
I had a well-worked-out forecast for what would happen to stocks after the midterm elections. It was smart, logical, and 100% wrong. Quite why is an interesting question, and shows how hard it is to predict markets even when events go exactly as predicted.
My flawed prediction was that U.S. stocks would fall in the event of the widely expected Democrat win of the House and Republican retention of the Senate. The argument started with the probabilities. Bets on the Iowa Electronic Markets before polling day had the split Congress at about 60%, a roughly 30% chance of the GOP keeping House and Senate and a “blue wave” giving the Dems control of both at just 10%.
Continued Republican control would have led to hopes of more stock-market-friendly tax cuts, and the probability was high enough that it was an obvious trade to profit if that one-inthree chance happened. It didn’t, so I expected those bets would be unwound, leading the market to fall.
There are three decent reasons why I was wrong, and the reason the stock market soared after the election could be down to any one of them, or parts of all of them.
First, I was looking at the wrong market. Rather than
stocks, the focus should have been on the dollar and Treasury markets, which followed exactly the playbook I’d set out. When Fox News called the House for the Democrats at 9.30 p.m. the dollar tumbled, Treasury yields jumped and investors unwound their bets on yet more deficit-busting tax cuts. Stock futures were basically unchanged for hours afterward.
Second, investor psychology. Bond investors often accuse shareholders of being driven by emotions, and perhaps there was an element of emotion at work. Alan Ruskin, macro strategist at Deutsche Bank, points out that much of the analysis being circulated by Wall Street and reported by the media showed that previous midterm elections were typically
followed by a stock rally to the end of the year. This past record might have given investors — shaken by the October selloff — confidence to pile back into the market after the election.
Equally, investors might have just been nervous about the election outcome and holding on to cash to avoid the uncertainty. With the result out, they were ready to get back into stocks, pushing up prices. Either way, U.S. stocks had a fabulous day on Wednesday.
The fact that European stock futures did basically nothing after the election until the equity market opened, when stocks soared — and that this coincided exactly with U.S. stock futures taking off — supports the idea
that nervous investors had held off buying until after the election. Only when the futures-market speculators saw real money going to work in stocks did they join in.
The third explanation is the least likely. Perhaps investors were so worried about the implications of a blue wave for stock prices that they had hedged their portfolio to minimize losses. When the wave turned out smaller than they feared, they no longer needed the protection, so could buy back in. The trouble with this argument is the timing: Why the big dollar and bond moves but little action in equities until European stocks opened?
A final suggestion is that investors thought Mr. Trump is now more likely to strike a deal on trade with China to avoid more tariffs, in order to bolster his position before the 2020 election. Leave aside the questionable logic here; the fall in the dollar would fit with this story (tariffs push up the dollar), but improved hopes on trade ought to help Chinese stocks, and didn’t, much. It is true that China’s market is much less connected to global stocks thanks to its domestic dominance and capital controls, but given the market was open, it was odd that stocks rose only 0.4% as the yuan rose against the dollar, and then stocks gave back all their gains and more even as the yuan kept rising.
I’m inclined to think both the first two explanations are right, and the obvious lesson is not to have too much confidence in one’s predictions of how the market will respond.
Even if you’re sure what will happen in some event, stocks might do something quite different. Moves in other assets can have big knock-on effects to the stock market. And anticipating how other investors will react — investors who are trying to predict each other’s reactions too — is typically more important in the short run than the true fundamental effects of whatever actually happens.
The basic advice is longstanding: Regard any short-term trade as no more than a punt, and expect to lose your stake.