First things first. While the full attention of financial market participants is focused on “Brexit” – last week’s British referendum to exit the European Union – the singular factor to recognize here is that the vulnerability of the financial markets to steep losses has very little to do with Brexit per se. Rather, years of yield-seeking speculation, encouraged by central banks, had already brought the financial markets to a precipice prior to last week’s vote.
It’s not entirely clear whether Brexit is a sufficient catalyst to burst the bubble, as we recall that the failure of Bear Stearns in early 2008 was followed by a period of calm before the crisis, and numerous dot-com stocks had already been obliterated by September 2000 when the tech bubble began its collapse in earnest. We’ll take the evidence as it comes, but we’re certainly defensive at present for reasons that have little to do with Brexit at all.
The high-level churning in global financial markets since late 2014 represents what we view as the top formation of the third speculative bubble in 16 years. For the U.S. market, valuation measures most reliably correlated with actual subsequent market returns pushed to the third most offensive extreme in history at the May 2015 market high, eclipsed only by the 2000 and 1929 peaks (see Choose Your Weapon for a ranking of various measures, and the chart series in Imagine for a current perspective). Because this speculative episode has infected nearly every asset class, rather than favoring tech stocks or mortgage securities as in previous bubbles, the median price/revenue ratio across individual U.S. stocks actually pushed to the most extreme level on record in recent weeks, before promptly retreating on Friday.
As I noted a month ago in Latent Risks and Critical Points:
“My impression is that the best way to understand the next stage of the current market cycle is to recognize the difference between observed conditions and latent risks. This distinction will be most helpful before, not after, the Standard & Poor's 500 drops hundreds of points in a handful of sessions. That essentially describes how a coordinated attempt by trend followers to exit this steeply overvalued market could unfold since value-conscious investors may have little interest in absorbing those shares at nearby prices, and in equilibrium, every seller requires a buyer.
“Imagine the error of skating on thin ice and plunging through. While we might examine the hole in the ice in hindsight and find some particular fracture that contributed to the collapse, this is much like looking for the particular pebble of sand that triggers an avalanche, or the specific vibration that triggers an earthquake. In each case, the collapse actually reflects the expression of sub-surface conditions that were already in place long before the collapse – the realization of previously latent risks.
“Finding the specific trigger that causes the skaters to plunge through the ice isn’t particularly informative. The fact is that catastrophe is inevitable the moment the skaters ignore the latent risk or rely on faulty evidence to conclude that the ice is stable. The fracture in some particular span of ice is just one of numerous other spots that might have otherwise given way if the skaters had chosen a different course. Hitting that spot creates the specific occasion for the underlying risk to be expressed, but an unfortunate outcome was already inevitable much earlier.”
As I’ve regularly emphasized over time, particularly since mid-2014, valuations are the primary determinant of market returns on horizons of seven to 12 years but have a much weaker relationship with returns over shorter horizons. Over shorter segments of the market cycle, the hinge that distinguishes an overvalued market that continues to advance from an overvalued market that drops like a rock is psychological – the attitude of investors toward risk-seeking or risk-aversion. Because risk-seeking tends to be indiscriminate, we find that the most reliable measure to distinguish risk-seeking from risk-aversion is the uniformity or divergence of market internals across a wide range of individual stocks, industries, and security types, including debt securities of varying creditworthiness. Those measures deteriorated materially in late-2014, as investors finally began a subtle shift toward risk aversion that has persisted during the recent top-formation.
For those inclined to dismiss the dangerous combination of extreme valuations and unfavorable market internals here, on the basis of our own struggle with QE-driven speculation during the advancing half-cycle since 2009, see the Box in The Next Big Short for the full narrative. Given that our measures of market internals are unfavorable here, and our valuation measures didn’t miss a beat even at the 2009 lows, the bulk of our present concerns are based on factors that had no part in that struggle.
Despite the potential for Brexit to act as a trigger to express latent risks that have been steeply elevated for some time now, my strong view is that investors should not be misled into thinking that the specifics of this particular trigger matter all that much. We could write pages on the potential renegotiation points that Britain and the EU will need to hash out now that Article 50 of the Lisbon Treaty has been invoked. But for investors, the main objects of focus should be the condition of valuations and market action, particularly the status of market internals, and the position of the major indices relative to various trigger points that might result in concerted selling attempts by trend-followers. That’s particularly important since value-conscious investors will likely have little interest in absorbing shares at nearby prices.
