Despite U.S. midterm elections being less than two months away, the equity options market appears to be underestimating the potential for political risks, such as contested election results and delayed confirmations. Implied volatility for S&P 500 put options has reached relatively low levels, and the Cboe Volatility Index (VIX) is currently near its annual low. Analysts like Kevin Muir suggest that investors should consider gradually building portfolio protection, as the cost of hedging could significantly increase if political risk becomes a dominant market concern. This subdued options pricing exists amidst other market indicators like elevated equity positioning, rising Treasury yields, tight credit spreads, diverging single-stock volatility, and stretched earnings expectations, which collectively point to an increased likelihood of an equity market pullback and a repricing of volatility in the coming months.
The current low-volatility environment is evident in the VIX, which has fallen to around 15, below its long-term median of 17.6, and also in VIX futures, which show no significant premium for the midterm elections. Implied volatility for December S&P 500 contracts has dropped from approximately 16% in July to about 14%, while November contracts decreased from 17.5% to below 15%. This suggests that the market is not anticipating significant shocks from the elections, with some investors believing that solid corporate earnings and robust economic growth will continue to support stock performance regardless of the election outcome.
However, some analysts express concern that the market's current "fearlessness" leaves it vulnerable to unexpected shocks. While historically midterm elections do not always lead to major market disruptions, the period leading up to the November 3 vote could be volatile, especially if there's uncertainty over Congressional control or challenges to election results. For example, the S&P 500 has dropped 5% or more during the September to October period in 15 of the 24 midterm years since 1930. Julian Emanuel of Evercore ISI notes that despite the risks, the overall level of market implied volatility is "compellingly cheap," making it an opportune time for investors to consider protective options.
Several factors beyond the elections are contributing to this potential fragility. Goldman Sachs's U.S. equity positioning indicator has fallen to minus 0.9, a level seen during the March market. UBS's machine-learning framework, "Turbu-lens," designed to forecast market vulnerability, reached its highest level of potential market stress at the end of August. These indicators, combined with tight credit spreads and limited demand for protection, suggest that the market is ill-prepared for any significant downturn, despite current geopolitical tensions and bond market volatility. The core debate remains whether these "tail risks" will remain peripheral or rapidly escalate volatility if political disputes and other market stresses coincide.
