US stocks calm ahead of midterm polls, but markets may be underpricing the risk

US stocks are heading into the final two months before the midterm elections with an unusual sense of calm, but beneath the surface, market positioning suggests investors may be ill-prepared for a shock, according to a Reuters analysis.

Stocks remain near record highs despite recent bond market volatility, while the Cboe Volatility Index, Wall Street's main fear gauge, is hovering near its lows for the year. At around 15, the VIX is below its long-term median of 17.6.

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That calm contrasts with a potentially volatile period ahead. The November 3 elections could bring uncertainty over control of Congress and the policy implications of a change in power. The run-up to the vote is also packed with potential catalysts, including inflation and jobs data, a Federal Reserve meeting and a late-September US visit by Chinese President Xi Jinping.

Historically, September and October have been difficult months for stocks during midterm years. The S&P 500 has fallen at least 5% during the period in 15 of the 24 midterm years since 1930, according to a Cantor Fitzgerald analysis cited by Reuters.

Yet the options market shows little concern.

"The VIX curve is not expressing any premium ⁠for midterm elections," said Michael Purves, CEO of Tallbacken Capital Advisors, according to Reuters.

The election itself may not trigger a major market reaction, but a change in control of Congress could alter expectations around economic policy and create a more divided government, analysts said.

Democrats have gained a significant edge over Republicans in voter perceptions of which party has a better approach to the cost of living, a Reuters/Ipsos poll found. If Democrats take control of the House of Representatives, the shift from one-party control of the White House and Congress could add uncertainty to markets, said Julian Emanuel, lead equity and quantitative strategist at Evercore ISI.

"A Senate flip would magnify the dynamic," Emanuel said.

More worrying for some strategists is the market's broader positioning. Crowded trades, tight credit spreads and limited demand for protection indicate investors have little room for disappointment, according to Reuters.

UBS's machine-learning framework, "Turbu-lens", which forecasts market vulnerability over the following month, reached its highest level of potential stress at the end of August.

"It's been basically screaming, extreme fragility for the last several weeks now," Maxwell Grinacoff, head of US equity derivatives research at UBS, told the news agency.

Still, some investors see little reason for alarm. Strong corporate earnings and robust economic growth could continue supporting equities regardless of the election outcome, while investors who have bet against the market in recent years have been punished.

"The equity market here has been driven by one thing and one thing only, which is earnings," Purves said.

But the current calm could also make protection against a sudden market shock relatively cheap.

"The overall level of market implied volatility is compellingly cheap when compared to the risks engendered by the midterm elections," Emanuel said.

(Disclaimer: This article is based on inputs from agencies. These do not represent the views of The Economic Times)