Goodbye England

Photo courtesy of express.co.uk.
A panic rush for the exit door of a burning theater is likely to end up with people trampled to death. That’s why the first advice in such situations is to “remain calm.”

However, the second advice is to “find an exit near you.” If the theater is indeed going up in flames, it is a very bad idea to remain inside for no other reason than to show that you are unswayed by the surrounding frenzy.

That, in a nutshell, is the dilemma that Brexit, or last week’s decision made by the UK to leave the European Union, poses to investors. Stripped to its essence, the question is whether Brexit is about to set world markets aflame or whether it amounts to just a lot of smoke.

Some would undoubtedly run for the exit before calmly reflecting on the question, just in case that by the time they reach an answer they find that it’s too late. Those are the ones that pundits often scorn – the ones easily scared, who liquidate positions at the first sign of trouble. But, given how much people suffered through the financial crisis of 2008, it may be unfair to paint them as undiscerning lemmings. The rational response, especially for those who depend on their portfolios for retirement, may well be to choose a certain outcome (known losses) over an uncertain one (far larger losses down the road). This is because a portfolio that is subject to periodic withdrawals to fund living expenses can’t recover well in a falling market.

So will Brexit trigger larger losses? The market seems to think the vote was bad enough to send the British pound tumbling to its lowest level in decades, and the foreign exchange market is not one dominated by small-time retirees but by very large professional traders. So is the bond market, which is in an increasing state of disarray as many developed-market government bonds are trading at even deeper negative interest rates (which means that not only you won’t receive any interest from buying a German bond, for example, but that you would pay the German government for that privilege).

More worrisome, from the point of view of market dynamics, is the fact that the implied volatility of US stocks had started to go up well before the vote, and then kept climbing, reflecting the fact that at least some professional players have a dim view of the market outlook. The idea taking hold is that every market weakness that has been glossed over until now (decreasing earnings, higher dependence on corporate buybacks, a slowing economy, an explosion of private-sector debt, etc.) may find in Brexit a catalyst and bring the market down to levels that reflect those concerns more fully.

One of the more worrisome ideas is that the British vote gave a shot in the arm to similar anti-European forces. The more vocal ones in France, Austria and the Netherlands have already called for a similar referendum.

To be sure, it is exceedingly unlikely that any other EU member would allow such a vote, as it is now quite clear that UK Prime Minister David Cameron made an enormous mistake in doing so, not only because it triggered huge market and political uncertainty, but also because it cost his job and possibly condemned him go down in history books as the man who divorced the UK from Europe.

The reasons for the vote result have been discussed at length everywhere and we will not rehash them here. With respect to the market impact, our initial assessment is that it is difficult to see how this could be seen as a positive, or even neutral, market event. As we see it, the only way for the market to recover easily is for the UK Parliament to ignore the vote – which they can do, since the referendum is not binding. Barring that, increased uncertainty over the future of Europe seems likely to keep in place the going-nowhere, up-and-down market state that has ruled for the last two years.

There may be some positive outcomes for continental Europe in the long term, however. Multinational companies that were domiciled in the UK to gain entry into the EU could change address to a safer location within Europe, for example. While regulations in the UK are friendlier than in Italy, France or Germany, they hardly compensate for the large loss in market access that corporations are now facing. This would provide a boost to European economic activity.

Furthermore, while popular discontent with elites, globalization, technological advances and immigration has finally exacted its first victim, one can be grateful that it was the UK (who is relatively small and always had one foot outside of Europe anyway) and not Germany or France, which would have been the end of the Eurozone and triggered all-out chaos. If European authorities take due notice of what has happened and the danger of ignoring the complaints of their people, Europe may well emerge stronger by this vote.

This is a big if. But it is perhaps possible that the UK may prove to be the sacrificial lamb that ended up making Europe stronger. Such outcome would not become clear for many months, or years. For now, however, chances are that volatility and uncertainty will set in. This is when sensible investment plans that take risk control seriously are most needed. While panicking is never recommended, a sober assessment of risks is necessary to make sure that investment portfolios can still grow while not exposed to unnecessary dangers.

What now?

Our clients want to make sure that their investments are managed efficiently and prudently, and that they partner with an advisor who helps them cut through the market noise. We look at their specific situations and use quantitative techniques and solid execution expertise to build and maintain investment portfolios that are suitable for their needs. We try to identify when to buy or sell different asset classes, with a focus on controlling downside, seeing through the haze of short-term volatility, and looking at what securities are priced favorably at various times. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success.

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Market cares more about friendly Fed than Brexit vote

2016-06-20 08_42_27-Who cares about Brexit as long as our Friendly Fed is around_ - Inbox - mc@mccooThe US stock market has not made any new highs in more than a year. Because during the previous six years it went up 150% virtually without interruption, some fear that the market’s inability to break new records could mean that the rally is finally over.

To be sure, the rally has been met with this kind of distrust since the beginning. Its imminent end has been predicted many times, but it marched on for six years to the dismay of many observers who wanted to be first at calling the top.

There is no question that one day the market will stop going up. If history is any guide, it will come a time when it will slump and move sideways for a while, perhaps years. The trick, of course, is that nobody knows when that will happen, nor it seems likely that anyone will be able to identify the beginning of such phase even after it started.

One indicator that has raised red flags is the VIX, or “fear index.” This is a measure of the expected, or implied, volatility of the S&P 500 in the months to come, and it is always associated with a market decline because it reflects the price of insurance (through options) against a market fall. The stronger the demand for insurance, the higher the VIX.

The VIX has gone up sharply in the last few trading sessions, climbing to its highest level since February. While some of this is due to market weakness, the VIX surged far more than during similar recent market declines. To some, this is a sign that something might be brewing.

One does not have to look far for possible dangers. The most obvious could materialize next week, when the UK will have a referendum on whether to exit the European Union (“Brexit”). All observers agree that it could be quite disruptive to risk assets, at least temporarily, if voters choose to leave.

But this is not the only source of concern. Negative interest rates, not long ago considered impossible, are now entrenched in many developed markets. In addition, the pace of bankruptcies larger than $1bn is at its liveliest since 2009; closures at major retail chains now surpass any level since 2010; junk bond defaults are rising and expected to go up; the outcome of the US presidential election could prove quite unfriendly to markets, and so on.

While there may be many reasons for market participants to seek insurance against a market slump (and push up the VIX), another powerful indicator points in a different direction.
The correlation among assets and sectors has been falling, and this is usually a sign that investors are becoming less concerned about the chances of a market crash.

While the VIX, or implied volatility, is informative about investor mood, the correlation among assets – i.e. the extent to which they move together – is a key gauge of investor confidence: optimism leads to lower correlations, pessimism to higher correlations. This is because when market expectations take a hit, investors tend to sell their positions indiscriminately, pushing asset prices down in unison, thus increasing the correlation among them. Conversely, when investors are confident about market prospects, they engage in the minutiae of relative value, buying some assets and selling others. This drives correlations down.

Where are correlations now? While the higher VIX means that future volatility is expected to go higher, the fact is that actual volatility has decreased in the last couple of weeks, and correlations have fallen. This suggests that there is little evidence that pressure leading to widespread selling could be building behind the scenes. US equity sectors seem particularly well situated with respect to the last nine months, as both the correlation among equity sectors and the overall volatility of a hypothetical US-equity sector portfolio including small cap stocks are at their lowest point. A similar portfolio of global risk assets that includes emerging and non-US developed market stocks and commodities is in a somewhat less privileged state, but far from a “danger zone.”

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So while the cost of insuring a portfolio of US stocks has gone up, correlations do not point to a deterioration of market conditions. While this change in a flash, there is no evidence that market sentiment is currently souring.

A simple explanation to this might be that the VIX is going up simply because the market is seeking insurance in advance of the Brexit vote, but does not actually believe that, even if it goes through, it will lead to an extended market crisis. Investors might be buying insurance but don’t seem bothered enough to engage in substantial rebalancing of their portfolios.

This remarkable calmness in the face of highly unusual market conditions (like Brexit and negative rates) suggests that investors, rightly or wrongly, are quite reassured by the Fed’s retreat from earlier hawkishness. If this is what is happening, it is another reminder that the co-dependence between the Fed and the markets will not end anytime soon.

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