The Brexit Becomes A Reality

| About: Deutsche X-trackers (DBUK)

Summary

The UK voted 51.9% in favor of leaving the EU. This result went against most polls.

However, markets were too confident about a "Remain" result given the margin of error inherent in polls as well as the added uncertainty about referendum polling and decision changes.

Early referendum results pointed strongly to a "Leave" victory and gave an opportunity to take advantage of market mispricing.

It may be a good time to take profits from bets on a "Leave" result.

The UK has voted to leave the EU in a surprise referendum result. The final results indicated that 51.9% of votes were for "Leave," which is a nearly 4% margin of victory. Most polls had suggested that "Remain" would win by a few percent, which I thought was the most likely outcome as well. However, I did discuss that placing small bets on a "Leave" result appeared to offer the best expected return, as the market appeared to be fairly confident (80+% chance) in "Remain" winning, while I believed that "Leave" had a close to 40% chance of winning.

The UK Divided

The results of the referendum indicate some major differences in opinion about the EU within the UK. Scotland and Northern Ireland voted to "Remain," while Wales and England voted to "Leave." Within England, urban areas often favored "Remain," with London being a particularly staunch supporter of "Remain." London was the one area where it appears that "Remain" consistently did better than forecasted. In most other areas, "Leave" did better than forecasted.

Early Information Proves Valuable

It was possible to get a fairly good early read on the EU referendum results by comparing the results from the first places to report with Dr. Chris Hanretty's model. The early Sunderland result indicated a possible strong day for "Leave," and the results from the first couple of dozen areas showed that "Leave" was consistently outperforming the numbers it needed to reach 50% by around 3%. Thus, I mentioned the short GBP/USD currency trade to Distressed Value Investing subscribers before the markets believed that a "Leave" result was likely. Betting markets had "Leave" at around a 35% probability at that time.

The trend of 3% outperformance by "Leave" continued to occur in most areas, although "Remain" outperformed in London, which resulted in "Leave" ending up with nearly 52% instead of the 53% that I expected earlier in the evening.

Effects On Stocks And Currencies

The general expectation is that the "Leave" vote will be damaging to the British Pound and UK financial institutions in particular. Early market results are in line with these expectations, pushing the Pound down over 7% versus the US dollar, while companies such as Lloyds (NYSE:LYG) and the Royal Bank of Scotland (NYSE:RBS) are down around 20% on the London Stock Exchange.

I will need to take some time to attempt to understand the ramifications of the "Leave" vote on Europe, but have currently mostly reduced my short GBP/USD position and will probably close it off later, along with selling some of the put options I have on UK financial institutions. I think it is worthwhile to take some profits and figure that the catalyst that pushes down those items has already occurred.

Conclusion

The financial markets were strongly expecting a "Remain" vote, which is why the initial reaction to the "Leave" victory was so strong. While I did think that "Remain" was more likely to win than not, the markets did appear to price in too low of a chance of a "Leave" victory, allowing for some opportunities there. The opportunity was especially good after early results came in that indicated a strong chance of a "Leave" victory, but currency and betting markets were slower to react and still had "Leave" as an underdog.

Now that the catalyst (potential "Leave" victory) has occurred, I am closing off most of the short positions I initiated for that possibility. I think there may be potential buying opportunities as well if stocks get pushed down enough by this event.

Some ETFs that may be affected include EWU, FKU, DXPS, DBUK, QGBR, HEWU and FXB.

Author's Note: If you thought this article was interesting, please scroll to the top of the article and click on "Follow" next to Elephant Analytics. Thanks for reading!

Disclosure: I am/we are short RBS, LYG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.