4 reasons why the stock market will be volatile throughout October. And 3 reasons why this presents opportunities, Evercore says

  • US political tensions are expected to be a significant volatility driver in the stock market with this week’s upcoming presidential debate potentially acting as a catalyst.
  • Investors see the US election as the biggest risk to stocks, according to an Evercore ISI survey; the deVere Group found that 72% of 735 investors' biggest worry for 2020 was a contested US election.
  • Evercore outlines volatility risks and 3 reasons why, despite volatility and poor investor sentiment, the current market still presents opportunities.
  • “What is interesting to us is how the market risk reward has improved while sentiment has deteriorated,” Evercore ISI’s Dennis DeBusschere said in a recent note.
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US political tensions are expected to be a significant contributor to stock market volatility. Tensions have started to rise in recent days and there is an expectation they will intensify until and possibly after election day on November 3.

Investment analysts have been raising concerns about the potential of a contested US election and the impact this might have on the stock market. Last week, President Donald Trump gave validity to some of these concerns when he refused to commit to a peaceful transfer of power at a press conference.

Then over the weekend, Trump announced the controversial nomination of Amy Coney Barrett to replace judge Ruth Bader Ginsburg on the Supreme Court. Republican leadership is expecting to vet, hold hearings and confirm the nominee before election day, which is in 36 days' time.

US election tensions continue into this week with the first of the three rounds of presidential debates is set to take place. The debate between Democrat candidate Joe Biden and incumbent Republican candidate Trump is expected to be at the forefront of this week's market reaction.

Read More: US presidential debate will be more of a 'key driver' for markets than the next jobs report, one strategist says

Evercore ISI's Dennis DeBusschere, in a note on Sunday, said he expects the US election to be one of the drivers for significant volatility in the stock market. 

This volatility of a US election isn't only on DeBusschere's mind.

Last week, Evercore surveyed 362 investors and corporates between September 20 and September 23 and found most believed the US election is the biggest risk to the stock market.

Independent financial advisor deVere Group found that for 72% of investors their biggest investment worry for the rest of 2020 was a contested election.

"A contested outcome of the U.S. presidential election will almost inevitably send the stock markets into a temporary tailspin – and this is weighing on investors' minds," said deVere Group CEO and founder, Nigel Green, in a press release. "I would argue, they should try and use the volatility to their financial advantage where possible and appropriate."

Additional Volatility Risks

Investor sentiment was already starting to decline last week when the S&P 500 erased year-to-date gains and the markets nearly experienced a correction. The US election combined with following factors could generate volatility in the market, DeBusschere said.

Monetary and fiscal policy is driving uncertainty. 

Speakers from the Federal Reserve in recent weeks have "muddled the message" on monetary support and have suggested a fiscal stimulus is needed for US economic recovery, DeBusschere said. 

The uncertainty around a fiscal package prior to the election and the Fed's willingness to contribute to US economic recovery will continue to drive volatility.

Rising COVID-19 cases

There has been an increase in COVID-19 cases in a number of  European countries and in some US  states. The tightening of lockdown protocols across the European region has raised concerns about the speed of recovery and is weighing on investor's minds.

Investor anxiety

DeBusschere also noted investors are growing anxious about high stock valuations.

"Bottom line, volatility will remain high throughout October, but over the next few quarters, the outlook for risk assets is attractive and the market is a buy," DeBusschere said.

Investor sentiment is declining but the market still presents opportunities

The weekly American Association of Individual Investors' investor sentiment survey for the week ending September 23 experienced its largest weekly percentage-point drop since June and is at an unusually low level, signalling a decline in investor sentiment.

Meanwhile investors have not been buying into the S&P's new gains, despite the S&P reaching new highs compared to previous months, according to a graph from Evercore.

Evercore found that there was a decline in exposure to US equity markets for active investment managers, according to the NAAIM Exposure index, which represents the average exposure to the US equity markets reported by its members,

"What is interesting to us is how the market risk-reward has improved, while sentiment has deteriorated," DeBusschere said.

DeBusschere said that this decline in investor sentiment has created opportunities for investors willing to tolerate volatility. He outlines three reasons why the current market is still a buy.

Read More: 'Expect more stock-market weakness': A Wall Street strategist lays out how investors' most-trusted defenses against crashes are failing them at a critical time

Three reasons the market is still a buy

  • Consumer confidence is increasing

The US consumer confidence composite is continuing to improve.

"Thank housing, negative real rates, increasing PMIs, and a high savings rate. As long as job growth continues, confidence will improve," DeBusschere said.

  • The market still has an upside

Leveraging an equity risk premium of 5.5% and consensus earnings per share estimates, DeBusschere expects the market to have a 5.5% upside from where it currently trades, around 3,346 points. 

This market expectation is calculated from Aswath Damodaran's fair value model.

If volatility significantly reduces and the equity risk premium trends lower then the market could have even greater upside.

"In short, earnings expectations and cash return assumptions would have to come down significantly, assuming yields remain range bound, for the market to be a short at these levels," DeBusschere said.

  • Stocks could go higher

Evercore found that 87% of S&P companies have cash return yields above 10 year Treasury yields. The current market is attractive if yields remain high, and the reason yields will fall is if another recession takes place, DeBusschere said.

If there is no recession, then yields should remain higher unless margins decline.

"If [margins don't decline], stocks are going higher as the 3 major tailwinds – 1) strong housing 2) negative real rates 3) a high savings rate paired with high consumer confidence – underpin the next expansion," DeBusschere said.

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