Analyzing The Known Risks

I’m always interested to find out what investors are worried about. Not all their worries end up causing volatility and sometimes there is a negative catalyst that comes out of left field. However, it’s still valuable to review the known risks to determine if they will send stocks lower and find out how the negative events could play out. In other words, I look at the probability of the event occurring, what can cause the even to occur, and how much downside the market has if it happens. Calculating risk is as simple as multiplying the change of it occurring by the downside impact. The tough part is coming up with the chance of it happening.

Whatever the downside risk is, you want to avoid stocks when it occurs. This doesn’t mean it’s not important to determine that risk. We need to know the potential impact to tell if the market is pricing in the risk in correctly. For example, if the risk has a 20% chance of occurring and could cause 40% downside, the market should be down 8% already.

Forecasting price action is more difficult than that because there are always many events occurring at once. When there is a singular risk factor which is huge, it can drive the market and get it to ignore small data releases and earnings changes. An example of this is the financial crisis as investors were focused on the financial black holes. The data points were negative anyway, but the point here is the survival of the financial system being in play made economic data less important.

One other point I think is important is that I believe all risk is knowable. Black swans can be predicted. It’s simply that the mainstream media and most investors won’t see them as a problem until it’s too late. This misunderstanding of risk is what causes sharp crashes.

Investors' Concerns: The Mid-Term Elections

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The chart above shows the list of risks investors are most concerned about. I’ll start with the 5th most prevalent risk which is the U.S. Mid-term Elections/Political Gridlock. Firstly, as an investor, I love political gridlock. I would rather the risk of political actions be known. When the Congress is split or when one party fully controls Congress and the President is of the other party, not many major laws get passed.

The major legislation the government passes can be positive or negative for stocks, which brings uncertainty. Therefore, gridlock brings certainty which is good for stocks. It’s said that the President gets the most done in the first 1-2 years of his first term because that’s when he usually has the most popularity. Sitting presidents usually lose seats in Congress. In the current situation, gridlock would be most easily achieved by the Democrats winning the House.

The chart below shows the risk these elections present is a concern. The top one shows the average performance during each part of the election cycle going back from 1900 to 2017. From the beginning of the 2nd presidential year until the mid-term elections, stocks usually fall. The volatility this year had more to do with tariffs and a shift in sentiment, but investors are now looking towards the elections in November.

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I haven’t discussed them yet because the early polls are unreliable as the primaries haven’t occurred yet. I think it’s fair to get an early reading now because we’re inching closer to November. I think the economy in Q2 will be like the one voters are facing in November. On purely an economic basis, this election is much different from the GOP wave in 2010 because in September 2010, the unemployment rate was 9.5% and now it is 3.8%. That’s good for the GOP this year. On the flip side, according to Gallup, Obama’s approval rating was 45% in November 2010, while Trump’s current average rating is 43.3%. That favors the Democrats.

The combination of likely wins and seats not up for election gives the GOP 48 seats; this same calculation gives the Democrats 44. This means it is likely the GOP will keep control of the Senate. The PredictIt betting odds market has only a 24% chance of the Democrats winning 51 seats. Since the Vice President has the tying vote, the Dems need 51 and the GOP needs 50 for control. The generic congressional poll gives the Dems a 6.7% lead over the GOP, helping their odds of winning the House. The House has 204 seats likely going to the GOP and 197 going to the Dems. There are 34 tossups. To control the House, the Dems need 218 members. There is a 60% chance the GOP has 217 seats or less according to PredictIt.

My take is that the GOP will hold the Senate and the Dems will gain a very slim majority in the House which will prevent many bills from being passed in 2019 and 2020. I don’t see this as a negative for stocks since the tax cuts have passed and the President can keep cutting regulations without Congress.

End Of U.S. Bull Market

I will review some of the other risks in detail, but I can’t address the 2nd one which is the end of the U.S. bull market. I look at the economy and other markets through the lens of how they affect stocks. It’s possible for the stock market to crash and cause trouble for the economy, but I don’t see that as having a high enough chance to focus on. We saw the 10% correction earlier this year cause sentiment to go from very optimistic to pessimistic, meaning a sentiment shift alone doesn’t have the power to cause a bear market without any economic or earnings weakness.

Unwind Of ECB’s Stimulus

The global central bank policy tightening this year gained 10% of the votes in this investor poll. The most prevalent change is the ECB as it will be shifting from stimulative to neutral. The image below shows the timeline of the path to monetary policy normalization. The end date of QE has been set at December. In Q2 2019, the deposit rate is expected to be hiked and in Q3 2019, the refi rate is expected to be hiked. The maturing debt on the ECB’s balance sheet is expected to be reinvested through 2020. That means in 2021, the ECB may start an unwind program like the Fed started in October 2017. This ECB timeline is tentative because the current economy is already weakening before the asset purchases have even ended.

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