Brexit: Fun Times Ahead

| About: Vanguard FTSE (VGK)


Change creates dislocations. Dislocations are the best opportunities to generate alpha because analysts and market participants make more frequent and sizable mistakes.

Focus on what has changed in 2 categories: observed occurrences and expected developments.

Watch out for incipient reflexive loops – they take longer for markets to perceive.

The knife of alpha cuts both ways – don't forget it, and be cognizant of your actions' place in the context of the broader market.

Put on our thinking caps, folks: it's gonna be a good (choppy) one.

After the UK's Referendum on EU membership, there has been no shortage of panic-inducing hysteria and doomsday talking points. I won't trouble you with the histrionics here, but if you're interested in elevating your heart rate and getting a primal urge to close out all your positions, I recommend Googling "Brexit markets." But let's get to the real stuff...

... What is your job as a PM, strategist, etc? Well, you are trying to estimate prospective probability distributions for many different, disparate, and interrelated events, then manage risk and exposure according to the expected path. Specifically, you care about the likely direction of asset prices and macroeconomic variables in different countries over different time horizons. Unless you're a technical day trader (in which case you're already too far gone for me, or anyone else to save you), fundamentals over a months-long to years-long period should be your chief concern. This begs the question: how has the likely course of events changed due to Brexit?

Since the UK voted to leave the EU, what has actually occurred? There are two categories of developments:

  1. Observed changes (e.g. the British Pound (NYSEARCA:GBB) depreciating steeply, especially against the Dollar (NYSEARCA:USDU) and Yen (NYSEARCA:FXY)).
  2. Expected changes (e.g. markets expecting a higher likelihood of a 'chain reaction' of 'Frexits' or 'Spexits' or whatever else you want to call them - basically a full disintegration of the European political order, and pricing equities significantly lower as a result, as seen in FTSE movements (NYSEARCA:VGK)).

Unfortunately, like most things in markets, it's more complicated than this simple delineation. George Soros famously documented the bilateral feedback loop between the two categories of developments, in his theory of Reflexivity: While component #2 determines asset prices (conventional definition of an asset is exchanging a lump sum for a payment stream, so changing expectations about payment streams beget changing lump sums), there is a 'reflexive loop' whereby changing asset prices actually alter the course of events themselves. (To help elucidate this, the archetypical example is that the share price of a healthy company declines for no apparent reason, prompting management to make changes that unintentionally, and perversely, impair value, thus pushing the stock price further down and retroactively justifying the initial fall.)

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Differentiation opportunities are two-fold. Firstly, some price changes alter the relative attractiveness of different asset classes. For example, it would appear that banking stocks, a sub-set of the equities asset class, may have been hit harder than was warranted. For example, is the below chart really justified? Did the value of Barclays' (NYSE:BCS) business really decline by a third just because the UK voted 'Leave' on a non-legally-binding referendum? I'm not taking a firm stance here - that will be the subject of an upcoming piece on financial services stocks. I bring this up just to say that there have been very real changes in the state of the world, and when you compare those changes to your own perception of the world, compelling trades may surface.

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The second component of new opportunity comes from 'pricing the future', if you will. A distinct competitive advantage in the coming months to years will be facility with international politics, game theory, and the most important field of knowledge for investment: history. Getting beyond the doomsday theatrics and rationally assessing what is likely to happen will allow you to 'get a grip', so to speak. We all know the adage to 'be greedy when others are fearful' (I find its fraternal twin, 'be fearful when others are greedy' to be of less use). People have an instinctual aversion to uncertainty and make mistakes in light of that.

At times such as these, where the opportunity for differentiation expands rapidly, remember that the knife cuts both ways. For every big swinger who gets the dislocations right, there are a couple (or maybe very many!) small-time suckers who get taken to the cleaners. Gross alpha is a zero sum game, and net alpha is a negative sum game. Take this remark not as trying to discourage you, but as a means of politely reminding you that actively trading these dislocations is making an implicit bet that you know better than the most well-staffed and sophisticated financial institutions on earth. I don't say this to glibly or sarcastically put you down - I think many readers of this article genuinely will be able to profit from impending volatility. I write the above because it is far too easy to forget the arithmetic of active management.

Indeed, as the world becomes less certain (as it appears to have after Brexit), beyond the obvious deleterious effect on business confidence and global investment, the 'choppy waters' will serve to purge the field of active management. Personally, I have experience in hedge funds. What I will be watching for is the strong vanquishing the weak in my industry.

If you are involved in professional portfolio management, be aware of the impending test of your mettle: this is the point at which the 'smart' part of 'smart money' will either be rewarded handsomely, or be thoroughly debunked. By the time the waters calm - as they always do eventually - the field will have been relieved of many money-hemorrhaging charlatans, and be left with a more competitive and dynamic set of firms. A 'controlled burn' if you will.

If you've found this piece to be dreadfully lacking in concrete analysis, Bravo, you are correct. It serves primarily to set the stage for forthcoming writing, where I will describe my evolving perceptions (in extremely concrete terms) of what is occurring geopolitically, societally, and economically around the world and how those changes impact asset prices, and finally what to do about it.

Above, I alluded to the importance of placing financial markets in a broader context than is the norm in the financial press. Financial markets are based on reality and the impending period will bring about significant changes in the reality of the complex system we call Earth.

We are seeing, and will continue to see, a changing of the political guard. Insiders are out, and outsiders are in... do you see the problem with this dynamic over a sustained period? Who will be left to govern? Insights on political matters will be key in understanding the shifting context in which markets function. Demographics will become increasingly important, with extreme age polarization between the more and less developed areas of the world creating market asymmetries. Knowledge of technology and AI may be necessary to have even a basic grasp on reality, if artificial general intelligence is realized any time soon. So on and so forth.

Though these developments sound anomalous, remember that the world is already, well, screwy, for lack of a better word.

Before news of the referendum was blasted across media outlets globally, the world had a number of odd, relatively unprecedented characteristics: Pervasive negative yields (and inescapable near-zero yields where NIRP was not present), ever-rising global leverage metrics despite already record high levels of indebtedness, myopic growth prospects throughout the recovery, increasingly unproductive legislatures, declining trade volumes despite better and more affordable access to the global transportation network... the list goes on. Now, a volatile element has been added to the mix: A potential end to the dynamic of rising globalization, interconnectedness, and liberal openness, precipitated tangibly and symbolically by the British decision to exit the EU.

In short, the world may be on the precipice of changing drastically. Though historically, betting that the world as we know it is ending has proven to be a losing proposition, consideration of the possibility is nonetheless a key part of formulating a market outlook. Understanding the present, and in turn predicting the course of markets requires a grasp on the institutional (political) environment in which markets operate, the societies throughout which they allocate capital, and the game theory and psychology that describe participant behavior.

The confluence of these insights has a name: History. Thus, understanding history is the best preparation for navigating an uncertain and routinely misunderstood world. This leads me to my final, seemingly self-defeating claim: Understanding financial markets is not a sufficient condition for understanding financial markets. Chew on that one.

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.