Brexit Or Bubble?

Once a month I play poker with some friends.  One of the things a poker player always looks for is a “Tell” in the other players.  A Tell if you don’t know is a change in behavior by another player that gives clues in their assessment of their own cards.  If I have a good idea of the strength of your hand I can bet accordingly and hopefully improve my odds and results.

You may ask how this relates to your investment portfolio or financial plan especially if you don’t play poker.  Let me explain…

Last week, the citizens of the United Kingdom unexpectedly voted to leave the European Union, or to Brexit.  This created turmoil in European financial markets.  That would be expected as the whole process creates uncertainty.  Uncertainty means risk.

What we wouldn’t expect was the degree of volatility it created in US domestic financial markets.  Stocks plummeted in value and interest rates fell.  At a basic economic level most US companies will not be greatly impacted by Brexit.  In the end if it goes through, the US will negotiate trade deals with the UK that we would expect to be similar to those already existing with the EU. Yes there are some currency valuation issues that can influence financial results for multi-national firms, but over time these swings tend to be influenced by a host of other factors.

So, is this reaction in the US a Tell of something else?  Clearly it exposed a very nervous reaction by investors both individual and institutional.  Why would investors be so nervous?

I believe we have worked our way out of the last recession and created a massive financial asset bubble.  This was fostered by the Federal Reserve keeping interest rates artificially low.  Low rates and later Quantitative Easing (the process of the Fed “printing money” to buy bonds on the open market) have sent money into stocks and in some cases other assets like real estate chasing higher yields.  Meanwhile economic growth has stagnated for an increasingly long period of time.

Corporations, seeing fewer profitable places to reinvest their cash and profits have started to pay more cash to shareholders as dividends and also started and/or increased buying their shares back from shareholders.  It’s the latter that can get dicey.  If they use cash to make the stock purchases it reduces the capital base and increases metrics such as earnings per share (EPS) which leads to higher share prices for the remaining shareholders and larger compensation packages for top management.

Never ones to miss out on a good thing the management and directors of companies without spare cash decided to borrow money at historically low rates and buy back stock.  This changed the capital structure of these companies and of course drove up the prices of their remaining shares.  Some analysts have said that stock buybacks have been holding the market up.

I think Brexit is a Tell.  The US markets have been in a narrow trading range for over 18 months.  Without economic growth or real earnings growth there is no reason to go higher and cheap money keeps a floor.  I don’t know how much longer this can last but I don’t think it will end well.  Investors seem to know this as any event sends them running for the (Br)exits.

The Bottom Line:  It’s a bubble.

–Michael Ross, CFP®

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