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Jun 27, 201602:50 PMFinancial Perspectives

with Michael Dubis, CFP

Market insights from the surprise Brexit vote

(page 1 of 2)

I write this on Friday morning following the surprise vote by the British electorate to leave the European Union (EU). Most markets and polling believed the United Kingdom would stay put, and so priced them “remaining” into global market values. This “leave” vote was a surprise and this is why we’ve already seen a huge amount of market volatility in the aftermath of the vote.

What does it mean? Simply put, the British people voted for the U.K. to stand on its own in deciding its future policies, trade agreements, currency, and more, as opposed to being part of a larger union where member nations often have divergent opinions on how other members operate but all have to operate under one currency, the euro. The members of the EU have a big influence on how individual member nations run their countries and economies, especially if the individual opposes the group.

Socially, it’s very brave and bold for U.K. citizens to vote this way. If you’re a student of history and appreciate the value of “independence,” I think congratulations are in order to those people even if they now face economic headwinds. Hopefully, the impact will short-lived. On the flip side, they no longer have to face the ongoing ambiguity of dealing with other member nation problems or outsiders dictating of how they operate. They can once again make decisions for their own country. They aren’t beholden to the direction of the EU, the International Monetary Fund, and other global entities that are lead by foreign leaders who may or may not always think about what’s best for the citizens of individual nations.

Let’s now look at it from a market perspective. This is a great example of how an “unknown” or “low-probability event” influences a market. I’ve written this many times before: markets don’t really react to things everyone knows about. Markets react and price in most of the known information in the form of probabilities; they do not price in low probability or unknown events with the same weight. The vote to exit was a very low-probability event; subsequently, when an unknown or low-probability event actually shows up (i.e., the risk is realized) in the market, the market rapidly readjusts.

I say this all the time — risk doesn’t entitle you to return if the actual risk occurred! The risk occurred and — big surprise — returns dropped.

However, this does not mark the end of market pricing this event. It will take some time. The vote is technically not binding until it goes through further due process, but for all intents and purposes it should be assumed the Brexit will happen. This will take at least a couple years to orchestrate because there is simply too much paperwork, laws, and agreements to renegotiate to unwind this relationship. Subsequently, it is highly likely that the market attempting to price this event will continue to be volatile. That does NOT mean the volatility is always down. Markets may also overreact and over sell. It goes both ways.

It’s a common saying in the portfolio management business that markets in the short term are heavily influenced by behavioral trades of haste, short-term incentives (v. long-term) and some guessing, while markets in the long term are primarily fundamental — influenced by long-term economic growth and goals. Subsequently, given these recent results are highly ambiguous to the near-term future of European and global economies, I suspect there will be a lot of “readjusting” of emotions and opinion along with heightened volatility. Good or bad, don’t let your own long-term portfolio decisions be based on short-term emotions and haste.

There are also market forces that influence returns that are simply beyond fundamentals. For example, when markets drop in such a large percentage as they have, leveraged investors may likely start getting margin calls, forcing them to pay down their debt on fallen assets. This can lead to a vicious cycle because many leveraged investors will then have to sell the same investments to pay the debt, forcing further downswings until that layer of debt is normalized. How big an impact this could have is unknown. It may already be priced into the markets but that’s a good example of how leverage can be very bad in markets like this and influence valuation beyond fundamentals. As I’ve written before, leveraging your portfolio is mega stupid. Avoid behaving badly during any potential margin squeeze, if it happens.

(Continued)

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About This Blog

It is an understatement to say the world has experienced a radical shift in capital markets. There are more layers of information and opinions on the direction of the world than we've seen in decades. The internet and the media do not always make it easier, but Michael Dubis' contribution through IB blogs will help you sift through the noise and give you some perspective. You can find his company online.

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