Brexit and its Implications

After the shocking Brexit event, the S&P500 ended the week on another down note, losing 1.6% by Friday’s close. Volume jumped, as would be expected in a down week. And volatility also spiked, but only to summer highs, and still nowhere near the panic levels seen in January and February.

While warped a bit by the British political vote, the technicals stayed true their trends. The downtrend in price that began in early July has been re-established by last Friday’s major losses.  And the strength of the move on Friday suggests that more, follow-on selling — and losses — would be normal to see.  On a longer term basis, the topping formation that began two years ago is in full force. And after last Friday’s massive loss, this formation has only gotten stronger.

In US economic news, almost all of last week’s reports were bad. The FHFA house price index disappointed, and so did existing home sales. The Chicago Fed national activity index was a disaster. New home sales missed. Leading indicators crashed into negative territory instead of rising as expected. Durable goods orders plunged—both headline and ex-transportation. Just about the only good news was a slight beat in the weekly initial jobless claims report.

The big news of the week, and arguably the biggest news of the year so far, was the shocking vote in Great Britain to leave the European Union. Almost all polls and experts had expected the nation to remain in the EU. So when the results started coming in, with Brexit leading, the risk asset markets around the world started plunging, as did the British pound.

Just about the only assets that rose in price were government bonds and gold….both functioning as safe harbors for the storm that Brexit created.

The biggest question about the aftermath of Brexit is whether or not it will be the trigger that finally leads to material price drops in risk assets, especially in the US. Even after Friday’s drop, the S&P had only fallen a few measly percentage points from its all-time highs. And a true “bear market” had not been seen in the S&P since the Great Recession hit in early 2008.

The key point to consider is that risk assets, especially in the US, are still very highly valued, and that this high valuation—not any particular trigger—would be the fundamental cause of any future bear market. The trigger would be only that—a catalyst for the correction of some more fundamental distortion in valuations.

And at this point, it’s absolutely not clear if Brexit will be THE trigger, like Lehman was in late 2008….or if Brexit will only be a step toward the bear market, like Bear Stearns was in early 2008.

Unfortunately, answering this question accurately will take much more time, and it will be finalized only after the fact.

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