The 4th of July US holiday always seems like a good time to reflect on what is going on in the world and the current situation in financial markets.

Unfortunately, the events of the last couple of weeks have caught many traders by surprise and many have lost a lot of money.

Let’s analyse what’s been going on and then make some comments about what to expect in the coming weeks ahead.

Brexit Fallout

The biggest event of the last couple of weeks of course was Brexit whereby the British people voted by a majority of 52% to leave the European Union.

This outcome was highly unexpected and many traders got caught long on risk assets because they were confident that the country would vote remain.

Odds for remain dropped as low as 1.09 on Betfair before the votes started to come in which just shows how confident most people were over the result.

I was also confident that remain would win but I now realise that I made a number of fundamental errors.

First of all I made the foolish assumption that the financial and betting markets would be accurate predictors of the outcome. Betting markets normally get the odds pretty close but on this occasion they were off the mark.

A big problem in this case is that betting odds are dictated by weight of money and not necessarily popularity.

Thus, we had a situation where more people were actually betting on exit but greater sums of money were being laid down on remain. This pushed the odds of remain lower (bookies dropping the odds to balance their book) and this distorted the true probability.

Second, I made the basic error that voters would feel unlikely to vote against the political parties and leaders that they had previously voted in. Obviously I did not understand the true extent of the so-called populist vote and the anti-immigration rhetoric.

Third, my viewpoint was clearly based too heavily on my own biased social circle. 95% of people in my social circle and on social networks were heavily favouring remain.

However, my social circle is heavily biased towards people living in London and those on social media. These are mostly younger people. But it was the older generation that overwhelmingly voted to exit and they are almost non-existent on social media.

Lessons Learned

The point is that there were some clear mistakes made and I personally have learnt a lot from this event. It’s another reminder to always try and think in precise probabilities and give yourself a margin of safety as well.

The world is continuously changing and events like these show you can never be too confident in one outcome.

Going even deeper, the ramifications from the vote and the political disruption it has caused gives reason to believe that our current system of democracy is in crisis.

How can it be right when the majority of people in a country (albeit a slim one) vote against the wishes of the political figures that they voted in to decide such matters?

No black swan

Anyway turning back to financial markets, risk assets got clobbered by the outcome which is not surprising at all given the bearish talks from such figures as David Cameron, Tony Blair and George Soros.

The British pound was hammered down to new record lows against the dollar and stocks fell across the board. Many traders positioned long lost a lot of money in the process.

However, even though this was a 12 sigma move for the British pound and historically a major event, this was not a black swan.

gbp 12 sigma event

Black swans are those tail risk events that are inherently unpredictable. The move in the British pound was huge but it was also relatively orderly and came as traders reacted to events unfolding live on screen.

As such, the move was as much due to traders expecting the lack of liquidity and adding to the volatility. As @mikeharrisNY pointed out, the move paled in comparison with the move during the ERM crisis in 1992.

Screen Shot 2016-07-04 at 2.25.15 PM

Brexit Turnaround

Almost as surprising as the outcome of the EU referendum has been the subsequent reaction in markets over the last few days where we have seen stocks stage an incredible rebound while gold has rallied and government bond yields have hit new record lows.

bond yields

The mixed signals have been confusing for traders who see the drop in bond yields and rally in gold as a flight to safety juxtaposed against the theme of continued stock market strength.

This confusion is only compounded when you add in recent economic data (which has been poor) and the potential long-term effects of Brexit.

As a result, traders have been caught long going into the Brexit vote and then caught short after the vote expecting the volatility to continue.

brexit chart

What’s next?

It’s true that Brexit on it’s own, does not mean much to US equities because the UK economy contributes only a small percentage to the US and the global economy.

That could be one reason why the US market has bounced so strongly since the vote.

(Although I think a more likely reason for the bounce is the impact of algorithmic trading in thin markets. That, and the impact of some large buybacks that we saw last week in financials).

The real worry is that the event will lead to a full break-up of the EU and disintegration of the euro. Taken together, the EU is the second largest economy in the world so there are very significant implications from such an event.

Riskless world

At this point in time, I have to say I do not trust this market at all. There appear to be plenty of indicators flashing red but stock markets continue to power on oblivious to the dangers.

Government bond yields have hit record lows and price action in these assets has also been increasingly erratic. Non-farm payrolls have been trending down (this week’s number looks like it could be a big event), CPI numbers have shown signs of growth and the TED spread (another gauge of market fear) has been ticking steadily higher.

non farm payrolls

The fact that a potential break-up of Europe is being largely ignored by stock markets suggests a worrying level of exuberance and could be a sign that we are now living in a “riskless world” as claimed by a recent Deutsche Bank report. Which is basically another way of saying we’re in a bubble.

Overall, the events of the last couple of weeks show how difficult it really is to predict the financial markets. This proves once again the importance of having a strategy and sticking to it. This includes a strategy that prospers in volatile conditions as well as good times.

 


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