Brexit

I was off to my tennis match with a clear head on Thursday night as the S&P futures were comfortably higher given the clear indication that the Brexit vote was solidly moving in favor of the ‘remain’ camp.  The polls had been closed and initial results were rolling in.  Betting odds (typically the most reliable indicator in these scenarios) continued to show a 85% chance that the UK would remain in the European Union at this point.  Even beyond those odds, every prognosticator was still predicting that the UK would remain.  That included me.  This was the logical thing for UK citizens to do.

When I got home later that evening the complexion of the futures began to change.  Volatility became the norm as they switched from positive, to slightly negative, then to significantly negative.  By 11 pm central time it was becoming clear that the ‘leave’ contingency would win the referendum.  The futures showed a triple digit loss in the S&Ps.  This continued as I checked Bloomberg throughout a sleepless night.

Equity markets opened this morning at 55 points down.  This was half of the loss the futures were predicting in the wee hours of the morning.  By mid-morning the market recovered to down 38 points, or less than 2%.  But we then experienced a slow melt down throughout the rest of the day to end down 76 points, or 3.6%.  Emerging markets ended the day down 6%+ while the European bourses were off 11%+.

This was an ugly day for sure.  But we didn’t see panic in the market as compared to what the futures were indicating the night before and by what most seasoned investors had anticipated.

What happens next?  The Brexit vote is clearly a negative for the UK, no matter what some of the disillusioned politicians and voters say.  Not even an island is an island as uncertainty will slow investment spending.  Even the most conservative of assessments will lop off at least a point of growth.  As GDP forecasts are for 1.5% growth in the UK, this could very easily push the UK into recession.

But the question remains, how will Brexit impact global financial markets?  Many smart analysts state that this is a political crisis while our last debacle in ’08 was a credit crisis.  A credit crisis revolves around payments and settlements.  If a bank isn’t going to be paid by its debtor or other creditors, well then, the whole system gets gummed up.  So, the thinking goes, so long as the payment systems are in tact and well funded then the risks are significantly muted.

Furthermore, the size of the UK limits it potential damage to the global economy as it contributes less than 4% to world GDP.  So some perspective is necessary due to the small size of the UK.

At the same time, the UK is not Greece in that the UK was a member of the European Union but not a part of the common currency, the Euro.  This makes a transition out of the European Union much easier given that UK already has its own currency (the pound).  Thus, there could very easily be an orderly transition for the UK as well as the European Union.

And finally, those that tend to view the Brexit with an optimistic lens point to a Fed (as well as other central banks) that will remain accommodating in the face of improving domestic growth (2.5% forecasted real GDP growth) and even a whiff of some much needed inflation.

You can read more about this type of optimistic take on the situation from Cullen Roche here or from Paul Krugman here.

The counter to this optimistic take could be easily summed up from a quote I read from Peter Goodman earlier this morning, “No one really knows what happens now. The collective imagination leads to dark places.”  I believe that the rationale by the ‘glass half full’ camp is sound, but markets can be driven by emotion and uncertainty.  And emotion can be filled by a wave of nationalism that has the possibility of dismantling the Eurozone, taking away the currency which could be a catastrophe for the banking industry.  I do not think this is the base case, but one would be foolish to dismiss the fact that this political crisis could morph into the next financial crisis.

One day of selling in the market is not enough for me to panic.  The backdrop for stocks given a bumbling along economy and a Fed that wants to juice financial markets is not bad (even though valuations have become a bit rich).   At the same time, I will be watching the price action of stocks to determine if more defensive positioning is necessary over the very short term.

As always, please call or e-mail with any questions or concerns.  Have a nice weekend!

Chris

Fiduciary Standard

As I’ve written in the past, Independent Registered Investment Advisors (RIAs) are considered fiduciaries.  Brokers, the guys and gals who work for the banks and brokerage firms work under a suitability requirement.  This requirement literally gives the brokers to rip-off their clients.

I read a good article in Gawker this morning that discusses the fiduciary standard.  Here it is:  Gawker

Gut Wrenching Drawdown

From a post written yesterday, February 10th, by Michael Batnick, titled “You are owed Nothing”.

As you’re probably painfully aware, the S&P 500 hasn’t made any progress over the last two years. If you’re feeling a little frustrated, I have some bad news for you, this is how stocks works. The stock market doesn’t owe you anything. It doesn’t care that you’re about to retire. It doesn’t care that you’re funding your child’s education. It doesn’t care about your wants and needs or your hopes and dreams.

I absolutely believe that stocks are the best game in town. I don’t think there is a better way for the average investor to grow their wealth. However, this is called investing and the price of admission is gut wrenching drawdowns and sometimes years and years with nothing to show for it. If you can accept that this is the way things work, you can be an enormously successful investor.

Trying to comprehend the stock market’s drop?

Asset bubbles are rarely recognized by those inside them. But when the market correction materializes, the story is typically easy to relate.  In March 2000, for example, when the dot.com bubble burst it didn’t take long to understand that valuation metrics based on customers per click or “eyeballs” really weren’t enough to justify such lofty stock prices. No, a 107 Price-to-Earnings ratio (or, PE Ratio that is a time tested metric that, at 107, was showing an inflated stock market) in the Nasdaq stock index was, in retrospect, a simple rationalization for the precipitous drop in equity prices.  Or, in September 2008, when the credit bubble burst and investors figured out CDOs, “liar loans”, and bank balance sheets stuffed with worthless assets that were levered up 35-to-1, the subsequent run on the banks and stock market meltdown was easily validated.

But this is not 2000. Arguably, asset prices in certain areas of the market such as biotech, private equity and social media are frothy, however, the major stock indexes have reasonable valuations—which are rich, for sure, but still reasonable.  This is also not 2008. Domestically, we are not involved in a credit crisis.  Of equal importance there is little bank “counterparty” risk (the risk that banks won’t get paid back by other entities for loans made) so our entire payment system is not gummed up as it was in 2008.  Sure, there are real concerns.  But in past violent stock market corrections, the flashing red signals were smack dab in front of us upon the market’s decimation.

In this context, former chief economist of the International Monetary Fund, Olivier Blanchard states, “The stock market movements of the last two weeks are puzzling.” (I urge you to click here on this link and read Mr. Blanchard’s full article)  Mr. Blanchard disassembles the major concerns for global financial markets:  namely, China and oil prices (for a further bullish opinion on China’s significance on global markets, click here: Alan Blinder WSJ 01.20.2016).   Blanchard then goes on to offer his favored explanation for the selloff, which basically states that money manager are acting based upon some “herd” mentality by selling assets based on nothing more than “uncertainty”.  The implication is that there is no fundamental reason whatsoever, but just due to the fear of the unknown—“political uncertainty at home and geopolitical uncertainty abroad are both high.  The Fed has entered a new regime [basically impotent at this point].  The ability of the Chinese government to control its economy is in question.  In that environment, in the stock market just as in the presidential election campaign, it is easier for the bears to win the argument, for stock markets to fall, and, on the political front, for fear mongers to gain popularity.”

Although we can’t explain the market’s recent sell off with the exact precision of past sell offs, the theme of “uncertainty” is common to all major market routs.  When the internet bubble burst we knew the why but we didn’t know how far (the PE ratio shouldn’t, or couldn’t, have rationally been set at 107, but it should have been reduced by precisely what amount?).  In 2008, we knew the banks were in trouble, but their mere survival was in question leaving us uncertain as to the appropriate market valuation in a world that might not have major commercial banks.  What we should not dismiss in today’s market then is the emotion/human psychology of the fear of the unknown that drives investors to hit the sell button.

Some of the greatest investors of our time have asserted that the market is not always efficient.  George Soros, William O’Neil and even Eugene Fama himself have dismissed the idea of market efficiency in one way or another.  Soros’ theory of “reflexivity” is a commentary on the human capacity to change events by taking actions ahead of perceived expectations (that are inherently flawed) only to distort the outcomes expected in the first place.  So, for example, the expectation that slower Chinese growth will lead to lower stock prices—no matter if the premise is inherently flawed or not—can lead to lower stock prices.  In other words, lower stock prices beget lower stock prices.  It only takes this perception.

So, what is the strategy?  As Ron Lieber wrote in the NY Times, “Plenty of research shows that if you miss just a few days of the market’s biggest gains, your long-term portfolio will suffer badly.  If you decide to put a lot of your money in cash right now, how will you know when to get back in the market?  You’ll probably be looking for a sign, and that sign will be the rebound days on which you missed out.”

I agree.  It’s not time to panic.  Remember, corrections are normal.  “It would take decades of systemic economic erosion to prove otherwise, and a few weeks of market declines do not suggest that anything like that is upon us,” says Lieber.  Each year the stock market has averaged one 10% correction per year.  We are now down approximately 9% in the S&P in the first few weeks of January alone, while down close to 12% from a November 2015 high.  A brutal selloff, for sure.  But as I don’t recommend going to all cash, some paring back of positions to become more defensive (for accounts that were more aggressively positioned) is a strategy that has been in order.  Historically, half of these 10% corrections turn into 20%+ corrections.  If and when stocks break through to the downside to the next level of support (1823ish on the S&Ps) it will be time to become even more defensive as the odds of a recession will increase (the idea of reflexivity where stock market declines impact the economy).

The next few weeks are critical. As Blanchard writes, “If it becomes clear within a few days or a few weeks that fundamentals are in fact not so bad, stock prices will recover, just as they did last summer, and this will be seen as a hiccup. If, however, the stock market slump lasts longer or gets worse, it can become self-fulfilling.”

As always, please call or write with any questions or concerns.

Friday Afternoon Reads–be scared of China’s debt, not its stocks

cartoon-golfer-008

Some things I’m reading this afternoon:

  • A new economic era for China goes off the rails (NYT)
  • Be scared of China’s debt, not its stocks (Bloomberg)
  • When China stumbles (NYT)
  • More downside coming in the S&P (AllStarCharts)
  • The man who crashed the market (TRB)
  • Fear & greed index (CNNmoney)
  • Wicker Park’s Double Door location could be sold to investment firm (Chicagoist)

Thursday Morning Reads–China trading halted

moneylink

Some things I’m reading this morning:

  • China’s 29 minutes of chaos (Bloomberg)
  • Goldman Sachs: this will drive markets in 2016 (CNBC)
  • George Soros sees crisis in global markets that echoes 2008 (Bloomberg)
  • Is the theory of secular stagnation a big hoax? (Telegraph)
  • Here’s what I think Donald Trump’s loss will look like (Vox)
  • An alarming new study says that charter schools are America’s new subprime mortgage (BI)

Wednesday morning reads–H bomb

links2

Some things I’m reading this morning:

  • Forecasting follies (AboveTheMarket)
  • Stocks causing angst, but is it an overreaction? (Barrons)
  • If China stumbles again, so will the stock market (Telegraph)
  • ‘Big Short’ hero is wrong this time (Bloomberg)
  • Why hedge funds are sucking wind (PragCap)
  • Does faltering manufacturing activity threaten a U.S. recession? (CapitalSpectator)
  • Chicago: America’s most segregated city (CNNmoney)

Tuesday Morning Reads–investors aren’t impressed with 2016

Links17662

Some things I’m reading this morning:

  • Investors see 2016 and they aren’t impressed (IBD)
  • U.S. stocks were hurtin’ even before Monday’s rout (LAtimes)
  • Recession talk is premature (EconomistsView)
  • A painful year for the contrarian trade (WealthOfCommonSense)
  • Byron Wien’s big surprises for 2016 (BusinessInsider)
  • Will the stock market’s house of cards collapse in 2016 (MarketWatch)
  • This may be 2016’s biggest threat (ProjectSyndicate)
  • Why it took 10 years to get ‘Making a Murderer’ to audiences (TheFrame)