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Playing the US Election

Richard Croft
November 7, 2016
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Playing the US Election

The US equity markets are re-setting some old records. At the close of trading last week, the S&P 500 composite index and the Dow Jones Industrial Average did something had declined for nine straight sessions. The last time we saw this measure of consistent bearishness was in December 1980 just before Ronald Reagan took office. Canada has done a little better although the iShares S&P TSX 60 index fund (symbol XIU, Friday’s close $21.46) has declined for the last six straight trading sessions.

 

Still, if the US market continues selling off into next week and following the November 8th vote, the Canadian market is unlikely to escape the carnage. The question is whether the back to back to back… down days are the result of political uncertainty or is it an early warning sign that the bull market has run its course?

 

While anything is possible, I am of the view that the sell-off was motivated by political uncertainty. Consider the evidence! The nine-day sell-off has been mild in that it was only a third of the decline witnessed in December 1980. Back in 1980 we had no real measure of volatility so comparisons are difficult. However current volatility has not expanded dramatically echoing the market’s orderly decline.

 

Some analysts have argued that Trump’s policies would be bad for the economy and thus the equity markets. Proposed tax cuts would cause a significant bump in the deficit and his promise to re-negotiate trade deals could push a fragile global economy into recession.

 

That concern was muted two weeks ago when Clinton had a sizeable lead in the polls. Although even then, analysts were uneasy believing the market was ignoring the possibility of a Trump victory. As the polls tightened and that concern became a real possibility, the market’s orderly sell-off may simply be its’ way of pricing in that possibility.

 

If that’s true, then any reaction to a Trump victory should be muted given the market’s current valuation. Keeping with that theme a Clinton victory should lead to a short term run up in stocks effectively re-capturing the losses from the current swoon.

 

Like most date specific event driven scenarios reaction is likely to be short lived. After the initial rally or sell-off investors will invariably return to fundamentals. A slow down in earnings and a likely increase in interest rates after the Federal Reserve’s December meeting. None of which are likely to motivate investors to buy leaving us with more of the same… a trading range scenario into the first quarter of 2017.

 

If you buy into a short term market move based on a my event driven scenario and subsequent end of year trading range that reflects longer term fundamentals you might consider non-directional calendar spreads.

We start from the premise that markets will move sharply on Wednesday after the votes are tallied. Assuming of course that we have a definitive outcome where the loser concedes to the winner. If not, all bets are off as it will take time for the courts to adjudicate the decision.

 

The mid-week move either up or down should be short lived lasting perhaps a couple of days or until the weekly options expire on Friday. I note at the close of trading Friday that XIU November 21.50 calls were trading at 19 cents per share while the XIU November 21.50 puts closed around 16 cents per share. If you sold both the November 21.50 call and November 21.50 put you should receive 35 cents per share.

 

At the same time, you would buy the XIU January 21.50 calls and January 21.50 puts for a total cost of $1.05 per share. The net outlay for this trade is 70 cents per share which is the $1.05 cost to buy the XIU January 21.50 straddle less the 35 cents you would receive from selling the November weekly’s 21.50 straddle.

 

You should be able to close out one side of the trade for a profit at the expiration of the November options. If the market bumps up and then falls back, you could even exit the entire position on Friday. But that is not the most likely outcome.

 

More likely this will end up as a longer-term calendar spread where you re-write short term options against the XIU January straddle once the initial options expire.

 

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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