All The Brexit You Want: When The Elephant Gets Wild

by: Trading Mates Stock Advisor


What history and psychology experts have to do with the Brexit.

Will Britain leave the EU market for real?

Should investors follow any forecast on the Bexit impact?

What can you do now.

Niall Ferguson writes in The War of the World, "How are we to explain this central puzzle: the willingness of groups of men to identify one another as aliens when they are all biologically so very similar? For it was this willingness that lay at the root of much of the twentieth century's worst violence. How could Göring's 'great racial war' happen if there were no races?"

In "The World Until Yesterday" Jared Diamond writes: "in a traditional society […] if you do happen to encounter a stranger in your territory, you have to presume that the person is dangerous, because (given the dangers of traveling to unfamiliar areas) the stranger is really likely to be scouting in order to raid or kill your group, or else trespassing in order to hunt or steal resources or kidnap a marriageable woman". As Ferguson states "man, some neo-Darwinians argue, is programmed by his genes to protect his kin and to fight 'the Other'."

When life was "solitary, poor, nasty, brutish and short" identifying strangers as aliens was a matter of survival. The unconscious hate for strangers is hard-wired in our brain. There is no doubt that the 'Leave' party had a free ride on Britain public brain' circuits when picturing EU as 'the Other'.

Jonathan David Haidt a social psychologist introduced the metaphor of the Elephant and the Rider to explain the two independent systems at work at all times in the human brain. The rational and conscious mind is the Rider, the unconscious mind is the Elephant. The Nobel Prize Daniel Kahneman studied at length the two systems. The Rider allocates attention to the effortful mental activities, including complex computations. The Elephant operates automatically and quickly, with little or no effort and no sense of voluntary control. As Kahneman shows, most of the human bias are born from an over-reaction of the Elephant whose automatic impulses often make us prone to errors. If the Elephant is indeed the origin of much that we do wrong, it is at the origin of most of what we do right as well.

During the Brexit campaign was way too easy for the 'Leave' party to trigger the Elephant response in UK voters and given the actual result, way too difficult for the 'Remain' party to wake up the Rider and tame the Elephant.

As Kahenaman says, in "Thinking, Fast and Slow", organizations are better Riders than individuals when it comes to avoiding errors, because they naturally think more slowly and have the power to impose orderly procedures. Nonetheless, we would add that organizations have the same weakness that the Rider has: organizations may over-analyze and over-think things up to a point of inaction.

What most people left unmentioned during the Brexit campaign is that the Brexit referendum is a consultative one, not a binding one. The UK Parliament has no legal binding to bring Britain out of the EU. What we should hope is for the Rider to tame the Elephant and our Rider is the Parliament now.

The history of Europe should tell you that ignoring a public referendum outcome is no so uncommon for European countries. According to the BBC, the Parliament was already prepared for doing so in case the majority of UK citizens would vote to exit the EU (check here). Nonetheless, the possibility for a Rider to fall into a spiral of over-thinking and inaction is still very real.

What will happen if Britain is really leaving? The truth is: no one knows. There are several researches out there that span from the next big world recession to rosy scenarios for both UK and EU. The point is clear, as engineers know very well, when you get a complex non-linear environment to study, forecasting become very difficult and you just have to acknowledge that you simply don't know. It is better for you to use some safety coefficients in your design. Similarly to engineers, you should have used some "safety coefficients" while designing your investments. Markets are crashing because investors hate uncertainty. An option, to prepare for Brexit, was to have enough dry powder to take advantage of the windows of irrationality you can spot when an Elephant gets wild. Another option was to properly hedge your portfolio.

If the Britain really leaves the single EU market, UK will have two years to negotiate the exit terms and a new relationship with the EU. In a two-year time, the Rider will emerge and little by little all uncertainties will disappear. Regulators are ready to make what is needed to stabilize the markets. The Bank of England and the BCE are ready to provide liquidity as needed. When all the hype fades, the fundamentals will re-emerge and noise investors will stop to see the Brexit in every single short-term economic data. In the end, you may still find that the Brexit was "much ado about nothing".

So, what can you do know? Some SA authors point to the possibility to buy bitcoins OTCQX:GBTC as a hedge against market volatility. If, and only if, the UK Parliament actually proceed with the exit from EU this may be a good option. The EU would go probably through a long period of instability and bitcoins will probably provide good returns in the short-term. Nonetheless, we do not like bitcoins for several reasons: bitcoins depend on an algorithm and algorithms, exactly as fiat currencies, depend on human will, so we are not so confident that bitcoins will not be devalued over time; bitcoins typically face strong opposition from policy makers; bitcoins are widely used in the deep web for illegal payments and may attract heavy regulation in the future.

Another option is to buy the dip. But which dip? For instance, today the FTSE MIB, the benchmark stock market index for the Italian stock exchange, is south of -12%. While the Italian country has some structurally weak economic fundamentals, many of the companies in the FTSE MIB have very attractive valuation and provide safe dividends for income investors. The companies more exposed to the UK and that are part of the FTSE MIB index are the following:

FTSE MIB companies exposed to UK (% of Revenue)



























If you believe that the Brexit case will not end up in a domino effect and a total crash of the EU, you may profit from starting a seed position on the FTSE MIB or the Spanish IBEX 35 or the Greek FTSE/Athens 20. We consider the FTSE MIB less risky.

We personally believe that Europe may go through several years of restructuring but we give a low probability to a complete breakdown.

In US, the current correction to the S&P 500 SPY is still very limited, but may continue in the coming weeks. If that happens, we suggest to do a bottom-up valuation for single companies and to monitor closely insider buys. Insiders are "natural seller", they usually file more sells than buys transactions when market are healthy, but they become good buyers during a market turmoil. As you can see from the picture below, the aggregate SEC Form 4 filings plot shows that insiders switched from being natural sellers to be active net buyers when the market provided ample discount to fair values, precisely during 2009 and 2011 (yellow circles). In February 2016, insider almost became net buyers, signaling an increasing number of undervalued companies. If the US market go south again, monitoring the insiders may signal a good entry point.

Source: OpenInsider

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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.