Why You Should Embrace Uncertainty

Graph paper, a calculator and a pen on it.

Global stock markets continued to celebrate what they thought they already knew overnight — that Britain will remain in the EU.

Or will it?

The Wall Street Journal reports that the pound plunged around 9.30am this morning, following a big ‘leave’ vote in a key district:

The pound declined in sudden trading after a key district reported a big win for the Leave camp in Britain’s European Union referendum.

In Sunderland, 51,930 people voted to remain in the European Union, while 82,394 of the voters chose to leave, a far greater than expected margin in this the Labour-leaning port city where anger at the EU runs high. The announcement sparked a rousing cheer among those leaning “leave” on the floor of the convention center where the ballots were counted.

The market may have decided the outcome of the referendum already, but it’s likely to be much closer than people think…

Indeed, the early polls show the ‘leave’ vote is just ahead. This is not what markets expected. At one stage this morning, the ASX 200 was down around 131 points. As I write, it’s rebounded to be down ‘just’ 52 points. Expect the volatility to continue. If the polls swing around, we’ll finish the day in the green!

But there will be big reversals in US and European stocks tonight if the leave vote gets up. Overnight, US stocks jumped around 1.3% on the anticipation, or hope, of Britain staying with the EU. European stocks were up around 2%. The Aussie dollar soared.

Gold fell slightly, but rallied sharply this morning on the news out of Sunderland. Other risk markets reversed as well. As I mentioned, Aussie stocks are getting hammered this morning.

For all the talk and angst about the lead up to the Brexit vote, it hardly made a dent in the S&P 500. Perhaps the big banks and financial institutions were so confident that the Brits ‘wouldn’t be so stupid’ to vote leave that they never seriously thought about hedging their bets.

Have a look at the chart below. It shows the S&P 500 since the start of 2013. As you can see, since the start of 2015, the index has gone sideways. Concern over Brexit was little more than a minor correction. Over the past week, the index rallied as the ‘remain’ camp won the propaganda war.

But it’s pretty much gone nowhere. Since peaking in May 2015, the S&P 500 has made numerous attempts to break out to new highs. But it just hasn’t been able to do so. That’s largely due to the Fed ceasing QE and attempting to raise interest rates.

Yet despite the lacklustre economy, it hasn’t fallen much either. You can thank prolonged low interest rates for this.

S&P 500 Index SPX 1 Day Bar Chart USD Weekly Layout

Source: Optuma
[Click to enlarge]

The S&P 500 is near record highs not because of robust earnings and a healthy economy. It is all about low interest rates.

Stock prices ‘discount’ a company’s future expected earnings. To do this, you need to apply a ‘discount rate’, which is an interest rate that supposedly reflects the risk of investing in stocks versus other assets like Treasury bonds.

Back in the early 1980s, when interest rates were high, the discount rate was high too. This in turn made stock prices cheap, although you didn’t really know it at the time. They simply reflected the prevailing risk involved with investing in stocks.

Let me show you a simple example of how a high discount rate can impact stock prices. Say a company has stable earnings of $1 million every year. A simple way to value this company is to discount these future earnings back into today’s dollars by applying an appropriate discount rate.

Say the discount rate is 15%. That gives the company a value of $6.66 million (1/0.15). Put another way, the company trades on a price-earnings ratio of just 6.66 times. This was roughly how the market looked in the early 1980s.

Fast forward a few decades to a period of deflation, quantitative easing and very low Treasury yields. The discount rate on stocks is now closer to 5%.

Our company, still earning $1 million per year, is now valued by the market at $20 million, 200% higher than it was previously, despite not increasing earnings at all.

That’s the magic of low interest rates, and it’s keeping the S&P 500 elevated. But until we get another catalyst, it’s hard to see what will push the market to new highs.

The Fed has eased back on their plans to raise rates, which is a slight positive for stocks. But it’s not enough to get the index to new highs.

That’s why it remains vulnerable to a negative shock, like Brexit. The more unsuccessful attempts to break out to new highs, the greater the risk of a larger correction unfolding. Markets don’t trade in narrow ranges for a prolonged period of time. It’s just not how they act.

Have a look at the chart again. The narrow trading trade in the first half of 2015 gave way to a big break lower. If this market continues to go nowhere over the next few months, you’re looking at a similar situation unfolding.

That is, stocks will either break sharply higher or lower.

That might sound like the most useless information you’ve received all week. ‘Thanks Greg, so you’re saying stocks could go up or down from here. Brilliant insight.’

Yes I am. And thank you.

The real insight is to have no bias as to which way stocks could go. Nothing is certain. If you’re bearish, and can list 10 good reasons why stocks must fall from here, it doesn’t mean they will. Likewise if you’re bullish.

The key to success in this market is to have a flexible mind. Nothing is certain.

As Mark Twain wisely said: ‘It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.


Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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