VTS Community,

I had a great question yesterday and I think it’s important I take a few minutes to clear up this misunderstanding:

 

“Why don’t you use politics as part of your signals?  Why do you think it doesn’t affect markets?”

The first thing I want to make clear is, politics does affect markets.  There’s no doubt about that, politics does affect markets and events like the Kavanaugh hearing are being traded by market participants as we speak.  The midterm elections will also be strongly affecting markets, as do things like healthcare votes, tax plans, trade and tariff talks, meetings with foreign leaders, and everything else within the political sphere.  They all affect the markets.

The reason I don’t take those events into account and actually make trading decisions based on them is they can’t be modeled or predicted with any accuracy at all.  We certainly can’t put any numbers to them, and as a quant style trader that’s a requirement for any signal.  But it’s more than that.  There are two levels of uncertainty at play here:

 

1)  The outcomes can’t be predicted with accuracy.  Do you know how today’s Kavanaugh vote will go down?  I would imagine you have a guess, but do you know with any certainty?  Did you know that President Trump was going to win the election?  Maybe you suspected he might, but did you know with any certainty?  Do you know who will come out ahead in the midterm elections?  Again, we all have opinions, but do any of us know with enough certainty to actually put money on the line?  Maybe a few dollars, but not our retirement funds right?

2)  Even if we did know the outcome ahead of time…  so?  If you were the only person in the world with an accurate glimpse into the future and you knew with 100% certainty that Kavanaugh will be confirmed, do you then know how the market will react to it?  Not really, it could still go either way.  Maybe he gets confirmed and the markets like it, or maybe they don’t and we see a sell-off.  Maybe he doesn’t get through and markets go up on the news.  The point is, even correctly predicting the outcome ahead of time, even that doesn’t tell you how the markets will react.

 

It’s like earnings reports.  The first level of uncertainty is that we don’t know what the report will say until it’s out.  The second level of uncertainty is, even if we correctly predicted ahead of time, we still don’t know how the markets will react to it.  There are plenty of times a company beats expectations and the stock sells off.  There’s plenty of times a company reports disappointing results and the stock skyrockets on the bad news.  We just don’t know.

So I really think this is an important distinction.  It’s not that I don’t think politics affect markets because there is no doubt in my mind it does.  The reason our trade signals don’t take politics into account is that they can’t be modeled and the two levels of uncertainty can’t be rectified.

 

As a risk manager, my main job is to account for and protect against as much of this uncertainty as I can.  There have been a few times in the past that I felt a political event was large enough to warrant moving to cash for a single day.  The Brexit vote was one of them, the US election night was another.  It happens.  Every once in a while an event is so binary, with sufficiently large asymmetric risk to the downside that we do just move to cash and wait for clarity.

Honestly, there are political events going on all around us every single day.  I think it would be a mistake, and a costly financial mistake at that, to attempt to move in and out of trades based on personal opinions of what the outcomes will be.  As I say often, all we as investors can do is make sure probability is on our side, and from there we just trade the math.  If it can’t be modeled in a formula, it’s not useful to us.

 

Side note, I took a little drive in the car this past week to one of my favorite places in the world.  Lake Moraine in Lake Louise Canada.  I’ll leave you with a small glimpse of this breathtaking place that hopefully everyone gets a chance to visit at some point in their life.  Have a great weekend everyone!

 

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