Your Reaction to Brexit May Be the Wrong One
Thursday, June 30, 2016

There is an old investing adage: “the market is always right.” Investors would be wise to question this adage in light of last week’s Brexit referendum. If the market is always right, then why were traders bidding stocks up as the British were voting to leave the European Union? For that matter, why did stocks drop on the two trading days following the vote and then rebound over the next two days? Optimism, fear and hope, all in the span of five trading days…

The efficient market hypothesis (EMH) describes stock prices as reflecting all known information. EMH has its proponents and its detractors. I would point to the recent reaction by the stock market as an example of the EMH theory failing to consider behavioral tendencies. Humans are not the rational decision makers many economic theories like to make us out to be.

Yet one does not have to embrace the EMH or view the market as always being right to appreciate an ongoing reality: The S&P 500 index is a tough benchmark to beat, especially over longer periods. Consider the performance of mutual funds. Nearly two-thirds of large-cap mutual funds failed to even match the 7.3% annualized total return realized by large-cap stocks over the 10-year period of 2006 through 2015. Put another way, investors would have been better off by owning the Vanguard 500 index fund (VFINX) then the majority of actively managed funds, even though active managers are being paid to beat the market.

This should give you a reason to pause before making any decision about what to do with your portfolio in reaction to Brexit. As I wrote on the AAII Blog last Friday, nobody knows what the eventual ramification of the vote will be. The referendum itself is not legally binding, although no leading British politician has yet to engage in the career risk of going against the voters’ say on this issue. There is no precedent for a country leaving the European Union. While Greenland previously negotiated an exit, it is a semi-autonomous territory of Denmark and not an independent nation. British prime minister David Cameron has resigned and news reports suggest both major British political parties are now in crisis. Scottish independence is again being raised as a possibility, while Northern Ireland has brought up the prospect of reunification. Good luck figuring out what the eventual outcome will be.

Humans like certainty. Our natural tendency is to gravitate toward clear forecasts—especially those given with a large amount of confidence. Yet clarity and confidence are far different from accuracy. The odds of making an incorrect forecast about the eventual outcome of Brexit are high. The more confident someone sounds when giving a forecast, the more should you be skeptical about what they say.

I fully realize that investing in the face of uncertainty is difficult. It’s hard to see how European economic growth will significantly improve until there is more clarity on Brexit. On the other hand, you should keep in mind how quickly market conditions changed following the 2008 financial crisis. Just as it seemed like everyone was staring into the abyss, the bull market started. The markets often move faster and with greater magnitude then our emotions can adjust to the new realities. Add in our cognitive biases—which include being unwilling to change our opinions even when the facts do—and you have perfect mix for underperforming the S&P 500.

So when thinking about the potential ramifications of Brexit, stop and take another look at what large-cap stocks have done over the last 10 years. Between price appreciation and dividends, they returned 7.3% on an annualized basis between 2006 and 2015. This return encompasses the worst financial crisis and economic downturn we’ve experienced since the Great Depression, Greece nearly being kicked out of the EU, Middle Eastern governments being overthrown along with civil unrest in neighboring countries, terrorist attacks, Ebola outbreak and aggravatingly slow economic growth. Hardly what one would describe as desirable investment conditions, yet stocks still rose. (The last 10 years were not an outlier either. Large-cap stocks have risen during 95% of all 10-year periods since 1926.)

There will always be monsters under Mr. Market’s bed and in his closet. Some will turn out to be figments of our or the media’s imagination. Others will materialize, but will end up being about as scary as Monsters Inc.’s Mike Wazowski. Very few will lead to bear markets. Even then, investors who adhere to a disciplined, long-term strategy will build wealth. Those investors who are reactive, however, will underperform, likely by a significant magnitude, regardless of whether the markets are right or wrong.

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The Week Ahead

The U.S. financial markets will be closed on Monday in observance of Independence Day. AAII offices will be closed on Monday and Tuesday. On behalf of everyone at AAII, have a happy Fourth of July!

Only two members of the S&P 500 will report earnings: Walgreens Boots Alliance (WBA) on Wednesday and PepsiCo (PEP) on Thursday.

The week’s first financial report will be May factory orders, which will be released on Tuesday. Wednesday will feature May international trade data, the June ISM non-manufacturing survey, and the minutes from the June Federal Open Market Committee (FOMC) meeting. The June ADP employment report will be released on Thursday. Friday will feature June jobs data, including the change in nonfarm payrolls and the unemployment rate.

Two Federal Reserve officials will make public appearances: New York president William Dudley on both Tuesday and Wednesday and Governor Daniel Tarullo on Wednesday.

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AAII Sentiment Survey

Optimism among individual investors about the short-term direction of the stock market rebounded to a four-week high in the latest AAII Sentiment Survey. Neutral and bearish sentiment both declined, but remain above their respective historical averages.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 6.9 percentage points to 28.9%. This is the ninth time in 10 weeks that fewer than three out of 10 survey respondents are optimistic. It is also the 34th consecutive week and the 67th out of the past 69 weeks with bullish sentiment below its historical average of 38.5%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 5.1 percentage points to 37.7%. The drop nearly negates last week’s rise. Even with the decrease, neutral sentiment remains above its historical average of 31.0% for the 22nd consecutive week. 

Bearish sentiment, expectations that stock prices will fall over the next six months, declined 1.8 percentage points to 33.4%. This is the third consecutive week pessimism is above its historical average of 30.5%.

Though optimism did rebound strongly this week, it is only barely within the range of typical readings. The rebound from Friday’s and Monday’s market drop helped boost bullish sentiment, though AAII members are already pointing to the uncertainty created by Brexit, as is observed in the responses to this week’s special question. There was also likely some reversion to the mean given last week’s unusually low reading for bullish sentiment. The longer-term trend of low optimism remains intact, with bullish sentiment only exceeding 30% seven times this year.

Giving individual investors cause for concern is the slow pace of U.S. economic growth and uncertain pace of global economic growth, terrorism and global unrest, lackluster corporate earnings, the prevailing level of valuations, the forthcoming November elections, monetary policy and Brexit. Some AAII members, however, are encouraged by sustained domestic economic growth, corporate earnings and the proximity of stock prices to their record highs.

This week’s special question asked AAII members how the performance of the stock market over the first half of the year compares to their expectations. Slightly more than one out of three respondents said the returns matched their expectations. A nearly even number of respondents said the returns exceeded their expectations (20%) or were below their expectations (21%). About 5% of respondents described the market as being more volatile than they expected. Respondents (especially those who described returns as matching their expectations) pointed to the sideways/flat movement of stock prices, slow economic growth, interest rates and their personal holdings as the reasons why.

Nearly 14% of respondents mentioned Brexit specifically. Several of these respondents said Brexit worsened performance relative to their expectations, with some saying the markets had been exceeding or matching their expectations prior to last week’s vote.

When we asked members in late December about how the S&P 500 would perform this year, slightly more than 20% of respondents forecast an increase of less than 5%, 31% predicted gains of between 5% and 10%, and about 13% called for a decline of between 5% and 15%.

Here is a sampling of the responses:

  • “About what I expected in a no-growth environment.”
  • “Performance has been ‘roller-coaster-like’ as expected.”
  • “Disappointing; had hoped for small gains.”
  • “Excluding the British vote reaction, the market has been about what I expected.”
  • “Performance has been worse. The market continues to overreact to short-term issues.”
  • “Surprisingly better than I expected. Continuing low interest rates are forcing people to buy into stocks.”


This week’s Sentiment Survey results:

Bullish: 28.9%, up 6.9 points
Neutral: 37.7%, down 5.1 points
Bearish: 33.4%, down 1.8 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

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