Dealing With Brexit And Its Aftermath

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As you're bombarded with stories about Brexit, you may want to keep two key things in mind.

First, Brexit's surprising victory on Thursday helps to confirm the two key major asset allocation trends that have prevailed: U.S. large caps and U.S. bonds (see "Are we still in a bull market").

Second, the stability of financial markets after Brexit is heavily dependent on investors' belief that key central banks have their backs. Should you begin to see stories indicating that this belief is on shaky ground, there are good reasons to become concerned.

Two major asset allocation trends reinforced by Brexit?

With the help of the two relative strength charts below, investors may be able to deal with two key asset allocation decisions: 1) How much to overweight U.S. stocks relative to international? 2) How much to lighten the weight in stocks relative to bonds?

First, with Brexit, U.S. large cap stocks will likely continue to be viewed as "the cleanest dirty shirt" versus international stocks. The chart below shows the price of SPY, the broad market ETF tracking the S&P 500, divided by the price of ACWX, the international stock ETF. The ratio of SPY/ACWX is known as relative strength.

SPY-to-ACWX ratio, or relative strength of S&P 500 to international stocks as of June 24, 2016, close.

Since the start of 2010, when the Greek crisis began, U.S. stocks were seen as the best bet as reflected by the fact that the SPY/ACWX price ratio has since risen by 89.3 percent. This was driven by the twin concerns about Europe, starting with the Greek crisis, and later starting in 2011, China and emerging market growth. The long-term trend of U.S. large cap stock outperformance remains strong, seen in the steep, upward trending slope of the red line.

Second, given Brexit's uncertainties investors will likely continue to seek the safety of U.S. investment-grade bonds. This second chart below shows the relative strength, the price ratio, of SPY to AGG, the U.S. investment-grade bond ETF.

SPY-to-AGG ratio, or relative strength of S&P 500 to U.S. bonds as of June 24, 2016, close.

Note that the ratio SPY/AGG has been heading down since around mid-2015, indicating that investors have been less willing to take on the risks of equities. It's possible that with Brexit the SPY/AGG price ratio line will make a second lower high to join the two lower lows already in place, indicating a developing downtrend - something to perhaps keep your eyes on.

This practice of tracking long-term relative strength trends is not about predicting the market. Investors who follow these trends are simply trying to stay in sync with the market, not forecast what the market might do. This is called "trend following," or "momentum investing," by quants and academics, who now believe it is by far the strongest "risk premium factor." If investors' portfolio stays in sync with the market's key trends, they should be less likely to overreact emotionally to unexpected events like Brexit.

Brexit: may not be a "black swan" but may create "tail risk"

Brexit's surprising victory also raises the issue of how to deal with unexpected market risks. Market pundits have been out in force after the Brexit vote saying that it will not lead to another financial crisis on the scale of that triggered by Lehman's bankruptcy on September 15, 2008.

It might be helpful to remember that very few of these experts predicted the outcome of the Brexit vote, and virtually none of them saw the Lehman moment and its full ramifications. So a lesson here is to take what the experts say with a huge grain of salt, knowing that no one can predict markets.

Of course everyone knew of the possibility of Brexit winning, but it just wasn't considered likely given the reported polling that had put "remain" marginally ahead. So in that sense, Brexit is not exactly a highly negative market event that seemingly came out of nowhere - otherwise known as a "black swan."

But it may eventually trigger what is called a "tail risk," which is the extremely low expected probability of a very large market loss. The underlying concern is that such large market losses have already occurred twice in the 21st century, far more frequently than would be expected under standard Modern Portfolio Theory assumptions used by many professional investors.

Investors are being reassured by market pundits that central banks and other key financial players have learned their lessons and won't make the same mistakes twice as they did with Lehman. While that may be true, investors may grow increasingly wary of the fact that central banks already may have used up most of their ammunition fighting the last crisis and its aftermath.

The ramifications of such a huge event as the Brexit vote means a black swan cannot be ruled out, given how fragile both the European Union and the global economy are right now.

One of the key differences between now and the Lehman moment is that the Brexit crisis and the Greek crisis before it are both intensely political in nature, which can threaten to spin out of the control of the elites in favor of globalization. This adds a new type of unpredictable uncertainty to financial markets.

Since the last financial crisis, so much of global private debt has been shifted to the public through bailouts, fiscal stimulus and quantitative easing. Also, a slow global economy combined with huge global inequality in incomes and wealth is a potentially toxic political combination.

Critical lesson of the Sept. 2008 Lehman moment

A refresh of what happened nearly eight years ago might help put the current events in perspective and why investors might want to be prepared for a potentially big tail risk.

First, it was not the Lehman bankruptcy and AIG bailout during the same week in September 2008 in and of themselves that created the ensuing global financial and economic collapse. Rather, the rapid collapse of the market was a combination of the rapidly spreading contagion in globally interconnected, highly opaque credit markets plus the loss of investor confidence in governments' willingness and ability to bail them out.

Lehman declared bankruptcy before U.S. markets opened the morning of Monday, September 15, 2008. That day the S&P 500 lost 4.7 percent from its previous Friday's close. The next day, AIG was bailed out with an initial $85 billion loan that eventually increased to an estimated $150 billion, indicating the scale of the problems.

But by the end of that disastrous week, Friday, September 19, 2008, the S&P 500 had actually gained 0.3 percent for the week! At that point, the S&P 500 was 19.8 percent below its all-time closing high on October 9, 2007, just very slightly below what is usually considered a bear market (aka, a 20 percent decline).

Yet from that date to less than six months later, the S&P had sunk another 46.1 percent further, for a total bear market decline from the October 9, 2007, peak of 56.8 percent. In short, the S&P 500 actually gained the week of the Lehman bankruptcy and AIG bailout, then fell 2.3 times more percentage-wise than it had in the earlier phase of the bear market before the Lehman bankruptcy!

A conclusion here is that the financial markets did not collapse immediately when Lehman failed and AIG was bailed out. They only started to collapse the week after that, when investors began to lose confidence in the willingness and ability of the government to bail out key financial institutions and stabilize markets. The first failed vote on the TARP bailout contributed to the market panic that governments were incapable of acting timely and forcefully.

A similar loss in financial market confidence in central banks and government happened in the European crises in 2011 and 2012, and almost triggered another huge crisis until investors heard the European central bank pledge that it was "ready to do whatever it takes to preserve the euro."

Financial markets have been propped up for years by key central banks, first by the Fed, then more recently the European and Japanese central banks have been buying up every government bond in sight for the past few years.

If investors were to ever lose faith in these central banks' unprecedented monetary experiments, then a huge tail risk will become increasingly likely. It is against that possibility that one might want to consider tail risk hedging, which we will explore in our next article.

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