Beware of Selling Ahead of the Election

Believe it or not, last week was a positive week for stocks. It didn’t feel that way, but it was.

The Dow rose 0.1%, the S&P rose 0.2%, and the Nasdaq Composite rose 0.8%.

It was easy to think equities were slipping last week because of waning optimism in the face of virus spikes across 26 U.S. states and across some major cities in Europe, and because two drug giants, Johnson & Johnson (NYSE:JNJ) and Eli Lilly and Co. (NYSE:LLY) had to stop vaccine trials on account of “reactions.”

If that news wasn’t disheartening enough, jobless claims rose unexpectedly, and there was no movement on a stimulus package.

While the “superficial” news and narrative-drivers were apparent as headlines, what was more interesting was what stocks were doing day to day last week – they were churning.

Churning Stocks and When to Buy

While big tech started the week off well enough, investors lost heart and switched to “cyclicals” or “value” stocks mid-week.

The “return of tech” as the leadership sector was encouraging at first, especially since what happened in August looked like it was happening again.

If you forgot what happened in August, options buyers kept bidding up call options on tech stocks heading into expiration, and dealers that sold those call options had to hedge against the rising market by buying underlying stocks against the calls they’d sold, creating a positive feedback loop.

As we approached options expiration this Friday, the same thing had happened: open interest in call options on the big tech stocks and bets they would go up were high, but we didn’t see the positive feedback loop pushing those stocks higher into the end of the week.

In fact, Apple Inc. (NasdaqGS:AAPL), where investors had tons of call options at strike prices at $120, $121, $122, and higher, closed on Friday at $119.02, rendering all those calls worthless. Chalk up one for the dealers.

What’s happening is important to understand.

Dealers fought back by trying to sell down stocks against which they’d sold calls, to keep all the money they took in. This time around, they didn’t just keep buying the underlying stocks and handing victory to call-buyers, this time they doubled down, didn’t ramp up underlying hedge buying and worked to push tech stocks down.

The insight here isn’t that dealers are bigger than the market, though they certainly can sway it at times, it’s that the “mindset” about tech stock had changed, and dealers bet correctly they could knock prices down.

They saw that through the prism of a Biden victory. As Biden increases his lead against Trump, investors, aware he’s going to raise taxes (including maybe taxing capital gains at the ordinary income levels), are starting to consider what that means.

The conclusion they’ve come to is other investors will start taking profits this year, maybe before the election (because if Biden win-selling might start with a bang, and it would be too late), so they’re not buying hand over fist anymore, not trying to move markets into expiration by bidding up the underlying stocks of the options they bought.

And investors who bought those underlying big-cap tech stocks, not because they had call options on them, but because they expected them to go higher, didn’t step up.

That’s what happened last week. That’s important.

It’s warning sign. As we get closer to the election and as Biden seems to increase his lead (though NOTHING in the polls should be construed as “a given”), investors may start taking profits off the table.

That’s the forecast now. Beware of selling ahead of the election.

It’s not going to stop the market from rising longer-term, but the weaker wall of this market is now, for the next few weeks, to the downside.


— Shah

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Source: Total Wealth