By Parke Shall
The world was stunned and shocked to end last week when the United Kingdom voted to leave the European Union. It was a result that almost nobody had forecast, but for a few people who extrapolated the numbers and did the tough work of looking through many of the small moving parts of the polling process.
While polls were mostly mixed leading into the referendum, there were occasional hints that the "leave" crowd had picked up momentum along the way and that things were running a little bit closer than most analysts had expected.
Obviously, things were much closer than expected. "Much closer" then sooned turned out to be, for all intents and purposes, a total blowout.
This caused a worldwide global selloff in equities as exchanges overseas in Europe and Asia sold off between 2% and 10% depending on geography and exchanges here in the United States had a horrendous Friday, shedding far more than 3% on each of the indices.
U.S. stocks, which were once up almost 2% on the week, finished the week down over 1.5%, an astonishing swing lower.
Even worse was that the selling accelerated towards the end of the trading session, leading us to believe that the selling will probably continue first thing Monday morning.
In today's article, we wanted to comment on why we think the "leave" crowd had enough gusto to push their side to a victory and why a similar mindset here in the United States could create far more volatility for the capital markets heading into the election in November.
We wrote yesterday about our feelings on the market now that the United Kingdom has left the European Union. To put it simply, we are bearish on US equities, and we expect most of the major indices to continue to fall another 10% to 15%. We want to see this period of correction push us to and through the short-term debt cycle bubble that we are dealing with after interest rates were lowered in 2008, but unless the Federal Reserve actually decides to have a spine, we're not sure how long it will take for these bubbles to burst.
Lower creditworthy individuals have fallen back onto peer-to-peer lending, a subgroup that while in question has been able to fill a niche need between those not credit worthy enough to get personal loans and those with no credit or poor credit. But this is just creating a bigger problem for when the chickens come home to roost, and trading in peer to peer lenders seems to forecast this.
The bubble is just getting a little bit bigger. We have also commented with that we believe there is a bubble in subprime auto financing and that any companies exposed to debt with onerous terms from individuals who may not be the most creditworthy are probably worth looking at to have a short position in. This includes names like Bank of Internet (NASDAQ:BOFI) and Bank of California (NYSE:BANC).
Back to Brexit.
Why did the United Kingdom leave? They left because the people in the "leave" camp were able to rally around a message that they were losing the sovereignty of their nation. Sure, remaining in the EU would have provided significant benefits for the UK moving forward, but the people have been sold a narrative that they are losing their country's individual rights and that the nation and that the country is participating in a globalized centralized government. Despite the benefits that this brings with it, people are scared of what they do not know and so many older working-class citizens who are fed up with the system voted to leave in order to get a point across.
We're not quite sure that these people understand the financial implications of such a move, but that's hardly worth discussing now that the damage is done.
New data was released yesterday that revealed that a majority of the "leave" camp were older individuals from a working-class background and a majority of the "remain" camp were younger individuals with more time ahead of them. Many of those who lived with the benefits of the EU from the late 80's to now want to abandon it and sever those benefits for a younger generation. It has certainly been an age based campaign for both camps.
We are not really interested in taking a political stance on either the US election or what just happened in the United Kingdom, but it is worth pointing out that it doesn't seem to be a great move for the capital markets. This is for obvious reasons, as exiting the European Union is going to send shockwaves through commodities and currency markets and this increase in volume to adjust accordingly is going to continue to create substantial volatility that, regardless of its outcome, the capital markets do not like.
Volatility is the enemy if you are a long investor in the capital markets and the United Kingdom exiting the EU is about as volatile of an event as you can get. It is going to take real time for the United Kingdom to make the necessary adjustments to fulfill the result of this vote and we can easily see more volatility in the markets ahead for the next 6 to 12 months.
Then we run into another peculiar issue, which is the election here in the United States. Regardless of what side of the aisle you are on, we think most people can agree that Donald Trump has tapped into a cell in the United States that many people did not think existed.
Many of Trump's supporters fear the same things as those who voted "leave". They fear that they are losing the sovereignty of the nation and they feel as if government is getting too big and too intrusive, limiting personal liberty. While that is not Trump's message per se, there is a strong overlay between his supporters and those who are from the "personal liberty" camp.
What does any of this have to do with investing?
The point is that if analysts can forecast the results of the recent referendum completely incorrectly, that this same type of grassroots feel may drive similar unexpected support in to the United States election in November. We are not saying that Trump is or is not going to be good for the capital markets, but what we will again state is that volatility is usually the enemy of the capital markets. With everybody expecting Clinton to win the election in November, A strong showing or even a win from the Trump camp could send a whole new set of shockwaves through the capital markets.
In conclusion, the point is that it is generally a very precarious time to be a long only investor. We stated just days ago that we were moving about 40% of our portfolio into shorts and keeping about 60% of our core longs. This is generally the most short exposure we will have on at any one given time, but we feel like we will keep this allocation for months to come. For shorts, we like banks with low lending standards such as Bank of Internet and Bank of California, as well as auto financiers like (NASDAQ:CACC) and companies that have large market caps but can't seem to turn a profit, like Wayfair (NYSE:W) and Tesla (NASDAQ:TSLA).
We were right when days ago we suggested that a United Kingdom exit from the EU could be the event that blindsides the capital markets. Nobody was expecting it to happen and there was a real chance of it happening, which is a perfect prescription for real volatility. Now, we are suggesting that investors look 2, 4 or maybe even 6 quarters ahead and brace for even more volatility. Despite the markets generally performing well during an election year, we have never seen an election like the one we are hosting this year and we think that this year's election may actually do more harm than good.
Those expecting a quick adjustment to the United Kingdom's exit followed by market bounces are misguided. We are preparing our portfolios for another 6, 12, or maybe 18 months of real volatility and we think that investor should consider this potential side of the story moving forward.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.