S&P 500 Analysis & ETF Trading

[kiy]

Nassim Taleb's book, The Black Swan 2007

BLACK SWAN


Taleb concisely summarizes what he calls a Black Swan in the following way:

"First it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable."

http://seekingalpha.com/article/3986434-black-swan-angry-brexit-carnage-continues?li_source=LI&li_medium=liftigniter-widget
With that in mind, let's examine the immediate aftermath of a very angry Black Swan that recently came ashore.

Brexit - An Unexpected Outlier of Enormous Magnitude

The European Union was long thought to be a rock-solid, unbreakable union of European countries. Politically, economically, and financially, a status quo built up around the EU; a status quo that those in power have worked hard to maintain at all costs. The EU is an institution that has become an expected mainstay of the global political, economic, and financial landscape, and the thought of its future demise once lived in the world of laughable conjecture. Until now.

Two weeks ago, voters in the United Kingdom shocked the world by voting to leave the European Union. Neither the betting markets, the polls, financial-markets participants, or even Nigel Farage, one of the faces of the 'Leave' campaign saw it coming. This massively unexpected event, an outlier event of enormous magnitude, has suddenly called into question not just the future of the United Kingdom, but the future of EU as well. Even though Brexit's impact on history will only be understood years down the road, in just a few short weeks, Brexit's impact on the financial markets is already being felt.

Financial-markets participants who focus solely on the United States may not realize the carnage that is continuing to occur in global-markets since the June 23 Brexit vote. Yes, at the time of this writing, the Dow Jones Industrial Average (NYSEARCA:DIA), S&P 500 (NYSEARCA:SPY), and Nasdaq (NASDAQ:QQQ) have recovered much of their initial losses, now down just 1.07%, 1.36%, and 2.06% respectively since June 23. There is, however, far more to the global investing world than the three popular U.S. indices. Let's take a look at what's going on in other notable assets.

The Carnage Continues

Given Brexit is the catalyst for the ongoing global selloff, the obvious place to begin is with the British pound (NYSEARCA:FXB). The British pound was trading around 1.50 just prior to the realization that 'Leave' might win. Thereafter, the selloff was swift and brutal, with the pound falling to the low 1.30s before bouncing slightly and making new lows on July 5, at 1.301. Clearly, when a major global currency sells off more than 13% in a very short period of time, something unexpected with an extreme impact has occurred.

The next obvious place to look is the equity performance of some of the UK's largest banks. Barclays (NYSE:BCS) closed at $11.18 on June 23, prior to the Brexit announcement. At the time of this writing, it stood at $7.20, down 35.60% despite the rally in major-market equity indices. The Royal Bank of Scotland (NYSE:RBS) closed at $7.49 on June 23 and stands at $4.22 at the time of this writing. That's a whopping 43.66% decline since the Brexit vote. Lloyds Banking Group (NYSE:LYG) is also a member of the 35% plus decline club, down 36.64% since June 23. HSBC (NYSE:HSBC) has fared better, only down 10.14%, after initially falling more than 15%. The breathtaking declines in systemically-important banks such as RBS and Barclays continues to be a reason for prudent long-term-focused investors to pause.

As an aside, for those anxious to buy stocks, I'd like to point out that since touching its all-time high in May 2015, the S&P 500 has failed at least six times to break out to new highs (coming close and being rejected each time). It already seems almost foolish to put new money to work at today's levels given falling corporate profits, excessive valuations, central banks losing credibility and pushing on a string, and the new uncertainty surrounding Brexit. Add to that the fact that for over one year the S&P 500 continues to fail to break out to new highs (new highs after this much consolidation would be a technical 'buy' signal), and it appears as if the upside is relatively limited and the downside is potentially massive. Yes, central banks around the world seem hell-bent on propping up stock prices. Unless, however, central bank intervention continues for the rest of your life, you will eventually live to see the consequences of the massive monetary bubble central banks have blown worldwide.

Now back to the Brexit carnage:
...the single biggest systemic threat to the global economy=Deutsche Bank...
Thus far, I've noted the pounding the British pound has taken, and the breathtaking selloff of some large UK financial institutions. The dramatic selling, however, has not been contained to UK banks. It also spread to some notable European financials. Deutsche Bank (NYSE:DB), which I view as perhaps the single biggest systemic threat to the global economy, closed at $17.84 on June 23. During trading on July 5, it was at $13.36, down 25.11% since the Brexit vote was announced. Credit Suisse (NYSE:CS), another systemically important bank is down 25.15% since June 23, while UBS Group (NYSE:UBS) is not far behind, down 23.17%.

Beyond UK and notable major European banks, the Italian banking system should be on investors' radars as well. A recent Wall Street Journal article had this to say:

Brexit has made what was already a serious Italian banking crisis worse. Italian banks are sitting on a combined €360 billion ($401 billion) of bad debts, equivalent to about a quarter of gross domestic product. This includes €200 billion of loans to borrowers now judged insolvent, which banks have on average written down to 45% of their nominal value but which the market appears to value at closer to 20% of their nominal value, which implies the system is short of around €40 billion of capital.

Now thanks to Brexit, the market fears that hole may be even larger. Lower Italian growth forecasts point to higher loan losses while falling government bond yields increases pressure on bank margins.

The only question now is how soon do the bailouts begin? Italian bank stocks have been getting crushed since the June 23 Brexit vote, with UniCredit (OTCPK:UNCFF) and Intesa Sanpaolo (OTCPK:ISNPY), down 34.20% and 32.16% respectively. On the Milan stock exchange, Banca Monte dei Paschi di Sienah has gotten absolutely obliterated, down 51.21% since June 23, while Banca Carige, and Banca Mediolanum are down 27.17%, and 17.79% respectively.

Yes, yes, I know, the Dow Jones is barely down post-Brexit. Everything is peachy. Tell that to bond investors. Since June 23, the U.S. 30-year Treasury (NYSEARCA:TLT) has fallen from 2.55% to 2.14%. I own a 4.50% coupon, 2036 maturing U.S. Treasury that is literally paying out more 10 years' worth of interest if I sell it right now. But I'm not convinced the 10-year Treasury will make it to 4.50% by 2026 or that yields on cash won't go negative in the coming years, so I'm still not selling. Speaking of the 10-year Treasury, it fell from 1.74% on June 23 to 1.37% on July 5. And judging where European bond yields are trading, the U.S. 10-year still looks cheap.

In Germany, the 10-year yield went negative after the Brexit vote, and the 30-year yield is trading at a shockingly low yield of 0.337%. In Switzerland, the situation is even worse, with 30-year and 50-year bonds falling into negative yield territory since the Brexit vote. The 30-year fell from a positive 13.7 basis points to a negative 8.4 basis points. And imagine accepting a negative yield for 50-years! There are no words to describe how crazy that seems. In the world of government bonds, the flight to safety is alive and well.

Next, let me turn to gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV), which have soared since the Brexit vote. Gold rose from $1,252 to $1,357 since June 23, while silver was the big winner, rising from $17.18 to over $21 before settling around $20.00. Silver has been on an absolute tear since January when it was trading under $14. What does it say about investors' faith in fiat currencies that gold and silver are performing the way they are? It appears the combination of negative-interest-rate regimes spreading throughout Europe and into Japan, along with massive uncertainty surrounding the future of the UK and the EU is enough for some investors to finally realize that over the long term, the current structure of the global financial system is not sustainable. An unsustainable system loaded with mind-boggling amounts of debt has never been a system that is kind to fiat money over the long run. Hence, precious metals, recognized as stores of value that have stood the test of time, have traded higher.

Finally, Brexit carnage has even spread to commercial real estate with the recent halting of withdrawals from several commercial property funds. First, £2.9 billion of Standard Life property funds was halted. As the recent article from The Guardian explains, "Investors in Standard Life's property funds have been told that they cannot withdraw their money, after the firm acted to stop a rush of withdrawals following the UK's decision to leave the EU." It smells like a fire-sale of physical shopping centers, warehouses, and offices is on the way.

The article continues: "'The selling process for real estate can be lengthy as the fund manager needs to offer assets for sale, find prospective buyers, secure the best price and complete the legal transaction'." Now that this story has gone public, it's virtually guaranteed the manager will be unable to "secure the best price" for investors.

Thereafter, two more commercial property funds announced halts. The Guardian's title, "Property funds halt trading as Brexit fallout deepens," says it all; the unexpected, massive outlier event that is Brexit has caused investors to rush for the exits. But the exit doors aren't big enough. Aviva's £1.8 billion fund was quickly followed by M&G's even bigger £4.4 billion fund suspending redemptions.

Why should anyone care about commercial real estate investors taking a hit? Here's an interesting excerpt from The Guardian on that subject:

In the UK, "around 75% of small businesses use commercial property as collateral for loans, so they could face problems with their banks if prices fall too sharply. Banks also use commercial property to count towards their capital buffers; at the end of 2015 around 55% of their core capital - their main safety net in a crisis - was based on commercial property." Everything seems to lead back to the banks.

It appears investors are starting to ask themselves why in the world anyone would want to own property in the UK, especially London, if the value of the pound keeps falling and the future of London's financial status in the world can no longer be accurately ascertained. With that in mind, Singapore's third-largest lender, United Overseas Bank (OTCPK:UOVEY), recently stopped accepting loan applications for properties in London. Investors may want to start considering where the follow through selling will occur if liquidity in UK commercial property is drying up (people will get their liquidity from somewhere).

To summarize, despite the Dow Jones Industrial Average, S&P 500, and Nasdaq holding their own (for now) in the post-Brexit-vote days, Brexit-related carnage has spread far and wide in the world of financial assets. From the British pound, to major UK and European banks, to the Italian banking sector, interest rates, precious metals, and commercial real estate, in just two short weeks, the Brexit vote is already having a notable impact.

I didn't even mention the fact that Germany's DAX (think of it as the equivalent of the U.S. Dow Jones Industrial Average) fell from 10,257.03 on June 23 to 9,532.61 on July 5 (after falling as low as 9,226.15 shortly after Brexit) or that France's CAC 40 is also down nearly 7% since June 23. And never mind the fact that Bank of America (NYSE:BAC), Citigroup (NYSE:C), Morgan Stanley (NYSE:MS), and JPMorgan Chase (NYSE:JPM) are down 9.90%, 8.64%, 8.50%, and 7.48% respectively since June 23. This must just be a blip, maybe even a so-called "fat-finger" hitting the sell button time and time again (note the sarcasm).

Now that investors have become so complacent in the post-financial crisis years and used to central banks doing everything in their power to prop up asset prices, it's understandable that so many people believe the carnage we've seen can't possibly continue. Surely, central bankers will save the day. One of the many lessons of recent years, is that central bankers will seemingly do everything their minds can imagine to prop up asset prices. It does, however, appear that with each passing round of QE and each additional interest-rate cut, central banks seem to be getting less bang for their buck out of stocks, GDP growth, and earnings growth; and that should worry those thinking about the long term.

Conclusion

It's become totally cliché for investors and money managers to say they are "investing for the long term." This phrase is often used to justify buying decisions that are otherwise difficult to justify. After all, in the past, major stock market indices have always recovered and moved to new highs. Therefore, investors operate under the assumption that what happened in the past will happen in the future, often without thinking about what it actually requires of the future to push stocks to ever higher highs. It's always seemed a bit sketchy to me that financial firms regularly put in the fine print of financial literature something to the effect of "Past returns are not indicative of future returns," while simultaneously promoting stocks by showing investors historical stock market returns. But that's the reality we live in.

With the arrival of Brexit, it seems as if mainstream financial-markets pundits have gone into overdrive trying to convince people to hold onto their stocks and to buy more. I suppose someone needs to get me a bigger bottle of Kool-Aid. I see in Brexit an outlier event with an extreme impact on the status quo and the financial markets; an event that only after the fact is now being treated by many as predictable and explainable, so as to convince people not to sell assets. When an angry Black Swan comes ashore, especially in an environment of falling corporate profits and excessive valuations, it's hard to blame people for wanting to exercise caution, even if their time horizon is the "long term."
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Mohamed A. El-Erian on BREXIT
Brexit has accelerated what I have characterized in my recent book as the journey to the neck of a T junction – that is to say, the exhaustion of the current road that the global economy is on, and the possibility of two contrasting transitions.

In the event that governments finally step up to the economic policymaking responsibilities and stop relying excessively on central banks, the recent period of low growth and artificial financial stability would evolve into high growth and genuine financial stability. The improvements would be turbo charged by the productive engagement of cash that currently resides on the balance sheets of companies, as well as technical innovations.

But if politicians continue to disappoint, low growth would turn into periodic recessions, and artificial financial stability would give way to disruptive instability. The inequality trifecta – that of income, wealth and opportunity – would worsen. Already-alarming youth unemployment would get even more deeply embedded in the structure of the economy. Political tensions would increase, as would the trust deficit in business and political elites, as well as expert opinion.

What is key to stress is that there is nothing pre-destined, at least as yet, when it comes to the road out of the T junction. It depends in large part on the political decisions that will be made in the comings months and quarters.

If you were forced to opt for just one outcome for Europe what would that be?

Having suffered short-term disruptions, both the EU and the UK would have regained their economic and financial footing in three years. The UK would have an association agreement with the EU that allows for the smooth trade in goods and services, and that lowers the risk of tariff wars. The EU would be a somewhat smaller but much more coherent, confident and operational unit.

And your biggest fear in the short-term?

It would be that de-stabilizing combination of policy mistakes and financial accidents.

Black Swan "First it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable."