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We Don’t Know Yet for Whom the Brexit Tolls

By Jim Pearce on July 1, 2016

In only one week the reaction to Britain’s vote to exit the European Union seems to have reversed course, swinging from shock to apathy. Despite dropping more than 5% in the two trading days immediately following the vote, the S&P 500 Index mostly recovered during the next three trading days for a net decline of less than 1%. That’s a bit unsettling, but hardly cause for alarm.

What’s surprising is the FTSE 100, the 100 largest companies traded on the London Stock Exchange, actually has gained 2.6% after also initially dropping more than 5%. This is puzzling given the nearly universal condemnation of the Brexit vote by economists and analysts who said leaving the EU would hurt the British economy in the years, and possibly decades, to come. Maybe investors think a new era of economic austerity is coming to help deal with the complications of cutting EU ties.

Then again, maybe the recovery has nothing to do with seeing silver linings. I point out that yesterday, June 30, was the last day of the most recent calendar quarter, a day when most professional portfolio managers’ performance is measured—performance that helps determine their bonuses. Yesterday the S&P 500 gained 28 points, which was just enough to book a slight gain for the quarter. So there may have been some financial self-interest at work by people who control enough money to nudge the markets to their advantage.

But sooner or later the economic impact of a major event like Brexit is reconciled by the financial markets. If nothing else, the immediate aftermath of the Brexit vote showed just how quickly, and severely, the financial markets can change direction when new information disrupts the status quo. And that’s exactly how financial markets are expected to behave.

But a bombshells’ short-term influence is often an emotional reaction based on incomplete information. And to form a long-term portfolio strategy we’ll need more information and a clearer picture of Brexit’s long term economic consequences.

The first set of dominoes are only now starting to fall, such as Boris Johnson’s announcement that he will not seek the office of British prime minister even though he helped spearheaded the Brexit movement and was widely regarded as the inside favorite to win the election if he ran.

This matters because the next British PM will be the person who oversees Great Britain’s departure from the E.U., which will require enormous tact and diplomacy to pull off without destabilizing its economy. For that matter, the next PM may decide not to go through with the Brexit, since it was a non-binding resolution.

More dominoes will fall, some of which can’t even imagine at this point. Will Scotland abandon Great Britain so it can remain in the European Union? Will Brexit motivate other EU members to head for the exit?

So while last week’s whipsaw markets looked fickle, they were actually telling. After the initial drop it didn’t take investors long to realize that there is not enough information to make definitive judgments.

So rather than trying to second guess a market that clearly does not know which direction it should go, you would be better served sticking to a disciplined process for identifying companies that are undervalued and likely to thrive regardless of what the ultimate fallout of the Brexit turns out to be.

For that I use my IDEAL Stock Rating System, which is limited to only S&P 500 stocks. Those are the biggest publicly-traded companies domiciled in the United States, which is the least risky place to own a piece of the global financial system. Until we have a lot more information about how the situation in Europe going to play out, stick with what you know so you don’t get blown around by the Brexit whirlwind.

 


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