A 3% Move Signaling Less Volatility?

Last night was a truly wild one – and I’m not just talking about the “blue-nami” with a “red undertow.”  What I’m referring to is the complete 180 that occurred in the market’s mentality while I was asleep.  From last night’s lows through this morning’s highs, ES December futures based upon the S&P 500 (SPX) had an intraday range of more than 3%.  Some of that can be attributed to putting electoral uncertainty behind us, but it’s quite difficult to reconcile a huge bout of “socially acceptable volatility” with the “lower volatility” explanation offered by many.

The overnight reversal is quite stark when we look at a chart that includes overnight trading.  ES futures broke below 7500 but are now about 7730.  That wipes out the losses that occurred on Friday and Monday.  NQ futures (based on the Nasdaq 100 (NDX)) have not risen quite as dramatically this morning (more about that later), so they are only back to Friday’s levels.  Either way, though, the overnight bounce is stunning.

6 Days, December ES (white, right scale) and NQ (blue, left scale) Futures

Note: Times are Central Standard Time, one hour earlier than Eastern Standard Time

Source: Interactive Brokers, past performance is not indicative of future returns.

The timing of the bounce fascinates me.  I went to sleep after midnight ET, and futures were trading just off their lows.  At that point, the broad strokes of the election were decided.  Both houses of Congress had been captured by Democrats, as had the governor’s mansions in Texas and Georgia, so there was no significant market-moving news that arose about an hour later to send futures vertical. 

The mindset change was likely spurred by overseas investors who responded favorably to political developments that might clip the wings of a President who is quite unpopular in large parts of the globe.  Several overseas-based investors conveyed that message to me this morning.

Plunging oil futures are a testament to that line of thinking.  Presumably the President will be less emboldened to continue battling Iran.  Certainly, the threatened post-election strikes have not yet occurred, although the buildup of military personnel and hardware in the region has not yet been reversed either.  One can certainly envision a Democratic-led Senate passing some version of a War Powers bill.  It might get vetoed, but remember, the original law was passed over President Nixon’s veto.  Defense stocks are getting hit hard this morning, so investors certainly perceive the potential for tighter congressional purse strings. 

That is why, when someone asked me about the causes for today’s rally, I offered the following:

1. Removal of election uncertainty
2. Foreign investors liking that President Trump got restraints
3. FOMO

Having focused on item #2, let’s examine #1, the removal of election uncertainty.  Anytime a “known unknown” that has been looming over the market gets resolved, we see implied volatility drop.  This is most typically seen after a company releases its earnings.  Options traders price in a bit of extra volatility ahead of the report, then remove that boost after the results arrive.  The same occurs after key macro news, such as an economic report, is released.  It was reasonable to expect a dip in forward-looking volatility measures like VIX and VXN after the election.  It was not widely expected that both measures would plummet by nearly four points each. 

There is a certain irony in basing a rally on a reduction of uncertainty on a day when we see a move of more than two standard deviations – more than three if we include the overnight session.  There are still many issues to be resolved, particularly surrounding data centers and the growth of AI. 

Regarding artificial intelligence, the election of Democratic governors in Texas and Georgia who want to throttle back the building of data centers has many investors spooked.  Those are two states, particularly Texas, where much of the buildout is occurring or slated to occur.  Hence, we see semiconductors and other suppliers trading lower, and thus NDX underperforming.  That is also why we see hyperscalers like Microsoft (MSFT), Amazon (AMZN), and Alphabet (GOOGL, GOOG) trading higher.  One reason is that if the supply of data centers is constrained, the existing cloud providers will see more demand that can improve margins.  Furthermore, a delayed buildout schedule might slow their immense capital plans, removing a bit of the concern investors were facing.  Here too, however, much of this is theoretical, as we are two months away from the inaugurations of the newly elected officials. And thus, we are faced with item #3, our old friend FOMO.  No one wants to miss a rally, and a day like today demonstrates that for many traders, fear of missing an upturn remains greater than the fear of an actual loss.  It also helps explain why Mr. Market can put a positive spin on a set of results that were seen as market-unfriendly just a few hours ago.  Nothing changes sentiment like price, at least in the short term.