Will Brexit Lead To An Extended Selloff In Stocks?

June 24, 2016

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Most Recent Comments Via Twitter

June 24, 2016

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Has The Reflation Trade Broken Out Yet?

June 23, 2016

Fed’s About-Face Helped Kick Off Reflation Trade

The Federal Reserve’s rapid reversal on interest rates in the first few weeks of 2016 helped launch the reflation trade. The reflation trade is also known as the weak-dollar trade; both refer to leadership from assets that tend to perform well during periods of rising inflation expectations and/or a weakening U.S. dollar. Reflation is also used to categorize the early stages of economic improvement after a period of weakness or contraction. In June, the Fed shifted to maximum dovish mode, which may help propel the reflation trade to new heights.

Sustainable Leadership From Weak Dollar Assets?

While there is no question weak-dollar assets have responded to the Fed over the past few months, the jury is still out on the question of sustainability. The chart below shows the performance of materials (XLB) relative to the S&P 500 (SPY). Notice how similar periods of leadership ended in disappointment (red arrows below). The reflation trade has worked its way back to a similar area (orange arrow).

Could Brexit Push Materials Over The Top?

As noted on June 21, the markets have been leaning heavily toward the “stay in the EU” camp on this week’s Brexit referendum. It is possible the Fed’s June shift and a favorable Brexit vote are able to push XLB over the hump. Time, price, and ballots will tell.

Does Trading Volume Favor Bullish Days Or Bearish Days?

June 22, 2016

Volume Is Only Helpful From A Relative Perspective

If trading volume for the S&P 500 ETF (SPY) was exactly the same every day, it would not be helpful. Volume analysis is a relative game. If SPY gains 1% on a Monday on 50 million shares and drops 2% on Tuesday on 100 million shares, it is easy to see some differentiation between the conviction to own SPY vs. the conviction to sell SPY. What can we learn from SPY volume in recent weeks?

SPY Gains This Week On Very Low Volume

SPY has gained ground on Monday and Tuesday of this week, but the gains occurred on trading volume that was lower than New Year’s Eve. Compare trading volume during the January 2016 sell-off (blue box below) to this week (orange box).

But Volume Has Been Low Recently

Yes; volume analysis is a relative game. Stocks dropped on June 10,13, 14 and 15; notice volume on those days relative to this week.

Brexit Is The Issue This Week, Right?

Yes, it is relevant. However, stocks posted gains on May 24, 25, and 27; compare volume on those green days to recent red days for SPY.

What Can We Learn From All This?

Is trading volume the best method available to manage risk? No, in fact volume analysis is not even close to the top of the helpful list, but it can add some value under certain circumstances.

The main takeaway is we can be more confident about rallies that occur on strong volume and we should be more skeptical of the sustainability of rallies that occur on low volume. Therefore, in the present day, volume is saying view recent moves in SPY with some healthy risk-management skepticism and understand that higher volume reversals would increase our concerns. Conversely, if SPY breaks to the upside on improving and heavy volume, our confidence in the sustainability of the breakout would increase.

Volume, viewed in isolation, is never a reason to buy or sell; it is one of many factors in the weight of the evidence equation.

Brexit And Fed Could Push Stocks Higher

As noted on June 21, the market appears to be anticipating a “stay in the EU” outcome this week. If voters cast their votes in line with market expectations, stocks could get a double boost if we add in the Fed radical shift that was communicated to the markets between June 15 and 17.

What Are Financial Markets Telling Us About Thursday’s Brexit Vote?

June 21, 2016

A Black Swan With A 124-Day Notice?

On February 20, 2016, U.K. Prime Minister David Cameron announced the EU Referendum would be held on June 23. When votes are cast this week, the financial markets will have had 124 calendar days to consider every possible relevant factor and every possible outcome. Given the S&P 500 is hovering near its recent highs and German stocks rallied 3.43% Monday, it is probably fair to say the most recent read by the markets favors the “stay in the EU” outcome.

In the chart of the DAX above, it is also noteworthy that German stocks are quite a bit higher today relative to the day the referendum was announced, which means fear has been waning rather than increasing since February 20 (see slope of dotted blue line).

What Can We Learn From The Currency Markets?

George Soros recently warned that a “leave the EU” outcome would have negative consequences for the purchasing power of the British pound. From the BBC:

“The value of the pound would decline precipitously,” he writes. “It would also have an immediate and dramatic impact on financial markets, investment, prices and jobs. I would expect this devaluation to be bigger and also more disruptive than the 15% devaluation that occurred in September 1992, when I was fortunate enough to make a substantial profit for my hedge fund investors.”

After the largest and most powerful hedge fund managers have had their staffs use the last 120-plus calendar days to look at every possible variable in Thursday’s EU referendum, are hedge funds selling the British pound to prepare for a “leave the EU” outcome? Not yet…in fact the pound is trading near its highest levels since David Cameron announced the EU referendum on February 20. Monday, the pound posted its biggest one-day rise in almost eight years.

A Stay Vote May Produce A Muted And Short-Term Response

Given the markets are pricing in and anticipating a “stay in the EU” outcome, it is possible that stock market bulls will be disappointed with the magnitude of gains, and more importantly, the sustainability of the gains in the financial markets. Logic says markets will have a positive reaction to a stay vote; the question relates to the magnitude and sustainability of the reaction, which would be something for the markets to decide.

A Stay Vote Will Not Cure All Of Europe’s Economic Ills

Has the U.K.’s membership in the EU over the past two years resulted in economic prosperity and new highs in European stocks? No, in fact the German DAX is currently trading at the same level it was over two years ago. When we wake up Wednesday, the U.K will be in the EU. If the “stay in the UK” vote prevails, when we wake up Friday, the U.K. will be in the EU, just as it has been during the last two years of stock market malaise.

The Good News May Have A Short-Term Impact

Therefore, the good news for the markets under the stay scenario primarily relates to the removal of a possible and unexpected negative outcome (leave the EU). However, a stay vote will not significantly alter the economic realities in Europe, nor the global economy. And given the market is preparing for a stay outcome, the stay scenario falls under the “that is what we were expecting” category, which is not typically what produces large and sustained rallies in risk assets.

Volume May Be A Tell This Week

If the market is anticipating a “stay in the EU” outcome and the market believed a large and sustained move would follow in the S&P 500, then we would expect stocks to be rising this week on heavy volume. Volume in the S&P 500 ETF (SPY) has been tepid so far this week.

The Wild Card Is If The Markets Are Wrong

Could the markets be wrong in their current assessment of Thursday’s vote? Sure, markets can be wrong, but that is the lower probability outcome. Large and sustained moves in markets come when markets are caught off guard and have to reprice for an unexpected outcome. Therefore, a “leave the EU” outcome has a much greater probability of producing a significant and sustained move in asset markets, especially relative to the expected “stay in the EU” outcome. In the end, the voters in the U.K. will decide, and the financial markets will determine the reaction. Our approach will be to be ready for all scenarios, understanding referendums and markets have an almost infinite number of variables.

Will Brexit/Fed’s Hyper-Dovish Shift Push Stocks Over The Top?

June 20, 2016

A Shift In Interest Rate Guidance

The Fed radically altered their outlook for interest rates last week, something that may have a significant impact on the stock market in the coming months. Keeping in mind the Fed’s shift in early February helped spark the current rally in stocks, last week’s developments improve the odds of the S&P 500 breaking out to new highs. From The Wall Street Journal:

“Wednesday’s moves marked a stark reversal from just a few weeks ago, when several Fed officials, including Chairwoman Janet Yellen, dropped strong hints they might raise rates in June or July. Instead, she emphasized the central bank’s uncertainty about when they’ll act and where rates are headed in 2018 and beyond.”

Fed Guidance Links

It is probably best to watch the video first, then come back and explore these links in the context of the chart above.

Point A: Four Rate Hikes In 2016
Point B: Little To No Hikes In 2016
Point C: June Hike Firmly On The Table
Point D: Yellen’s New Normal
Point E: One Hike In Next 30 Months

Video Explains Why This Week’s Shift Is Important For Stocks, Bonds, And Commodities

This week’s stock market video helps us understand why the Fed’s new stance calls for flexibility, as well as, risk management contingency planning.

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Video

Video

Yellen’s New Normal

In last week’s press conference, Janet Yellen described the current slow-growth environment as the “new normal”, which is a significantly different narrative than the one the Fed has been promoting in recent years. From The Wall Street Journal:

The combination of relatively stable economic projections and a lower interest-rate outlook suggests officials are coming to the conclusion that the economy simply can’t bear very high interest rates, even to achieve the mediocre growth and low inflation officials have in mind. Ms. Yellen previously said she believed temporary headwinds were holding back the economy. She conceded Wednesday that such drags, such as slow productivity growth, might persist.

Brexit And The Fed

Hypothetically, under the U.K. stays in the European Union scenario, the markets would have two bullish stories to rally around (Fed and Brexit). If the one-two punch comes after the June 23 votes are counted and stocks fail to break out of their recent malaise, it would be very concerning for the markets and the economic outlook. We will learn something either way. Ballots, time, and price will tell.

Will The Fed’s Latest Dovish Shift Save Stocks?

June 18, 2016

The Fed radically altered their outlook for interest rates this week, something that may have a significant impact on the stock market in the coming months.

Fed Guidance Links

It is probably best to watch the video first, then come back and explore these links in the context of the chart above.

Point A: Four Rate Hikes In 2016
Point B: Little To No Hikes In 2016
Point C: June Hike Firmly On The Table
Point D: Yellen’s New Normal
Point E: One Hike In Next 30 Months

Video Explains Why This Week’s Shift Is Important For Stocks, Bonds, And Commodities

This week’s stock market video helps us understand why the Fed’s new stance calls for flexibility, as well as, risk management contingency planning.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

Video

Video

Will The Fed’s Latest Shift Save Stocks?

June 18, 2016

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Most Recent Comments Via Twitter

June 15, 2016

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Brexit: Will They Stay Or Will They Go?

June 14, 2016

Polls Lean Go, Markets Lean Stay

A referendum is being held on Thursday, June 23, to decide whether Britain should leave or remain in the European Union (EU). Polls currently indicate a bias for the leave scenario. However, Great Britain’s wagering markets continue to show a bias toward the stay scenario. From CNBC:

“On Friday, a poll for the Independent newspaper gave a massive 10-point lead to the British voting public that want to leave the European Union. Over the weekend, another poll for The Times newspaper gave leave vote a small lead. A Financial Times Poll of Polls gives leave a lead as well — 46 percent, versus stay at 44 percent. Furthermore, while Great Britain’s vibrant wagering markets have shown the momentum build on the leave side, they still show a significant preference for remain. The latest odds on Monday — 4-7 for stay vs. 7-4 for leave — imply a Brexit probability of 36 percent.”

Pros And Cons

The excerpts below from the BBC’s “all you need to know” provide some insight into the case for leaving and the case for staying in the EU:

Why do they want the UK to leave?

They believe Britain is being held back by the EU, which they say imposes too many rules on business and charges billions of pounds a year in membership fees for little in return. They also want Britain to take back full control of its borders and reduce the number of people coming here to live and/or work. One of the main principles of EU membership is “free movement”, which means you don’t need to get a visa to go and live in another EU country. They also object to the idea of “ever closer union” and what they see as moves towards the creation of a “United States of Europe”.

Why do they want the UK to stay?

Those campaigning for Britain to stay in the EU say it gets a big boost from membership - it makes selling things to other EU countries easier and, they argue, the flow of immigrants, most of whom are young and keen to work, fuels economic growth and helps pay for public services. They also believe Britain’s status in the world would be damaged by leaving and that we are more secure as part of the 28 nation club, rather than going it alone.

Forecasts/Polls Have Been Shifting

Since polls have been shifting in favor of the leave scenario, it may take time for forecasting models to settle down. The graphic shown below comes from Matt Singh’s Number Cruncher Politics. Mr. Singh has stated this referendum will be the “biggest challenge” of a forecaster’s career, meaning markets will most likely be dealing with uncertainty until the June 23 votes are counted.

Market’s Don’t Like Uncertainty

All things being equal, financial markets tend to favor certainty over uncertainty. A vote to leave would raise numerous questions about the future of the EU. From Bloomberg:

With the June 23 referendum now just over a week away, repeated warnings of the economic risks of a Brexit have failed to sway voters… Earlier Tuesday, France’s largest insurer warned that there’s an “extremely high” probability of a Brexit. Neither Britain nor the EU as a whole is prepared for the negotiations that would follow a vote to leave and investors would face “a true landscape of uncertainties,” Axa SA Chief Executive Officer Henri de Castries said at a conference in Paris. Other countries could be encouraged to seek special treatment, threatening “to accelerate the unraveling of Europe,” he warned.

Last week’s concerning reversal in U.S. stocks occurred in part due to the ongoing uncertainty related to the June 23 referendum.