First Half Report, Brexit and More

Published at Jul 10, 2016, 12:00 AM in wealth management by Buğra Bakan

“Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.” Hyman Minsky

At first glance, the US stock market performance in the first half of 2016 can be summarized as a “all hat no cattle” type of action.

Put in other words, a sideway trend has been the name of the game, with a lot of volatility, only to end back to square one for large US stock indexes such as S&P 500 and Dow Jones.

The S&P 500 is almost flat with a 2.69% gain and an 11% drawdown, while Nasdaq finished down by 3.29% with a 16% draw down during the first half.

The story is quite different in European and Emerging Market stocks, and most importantly, in bonds.

Europe closed the first half (Symbol EZU) down 7.91% and Emerging Markets (Symbol EEM) up 6.74%…meanwhile we saw significant bond returns, a 20 Year Treasury Bond ETF (Symbol TLT) gained 15.19% in market value.

For those who are new to my market letters: bond values are inversely correlated with interest rates. As the interests (yields) drop, outstanding bonds with relatively higher interest payments become more attractive investors, and gain value.

During the first half of 2016, interest rates and bond yields have come down in historic ways with no precedence. First time in its history, 10 year German treasury bonds hit negative interest rate territory. US mortgage rates are at historic lows. All this signal a tremendous amount of worry in the market, waiting for a big drop in stock values, or risky assets in general.

Bill Gross, aka the Bond King, came out in the past few weeks and said (paraphrased) “…and so the returns of the last 40 years, may only be found in Mars in the upcoming 40-year period.”

Why so?

Why is there so much fear in the market?

Why do the investment returns of the past 40 years seem a difficult target to reach?

Stretched Valuations

Well, let’s start with stretched valuations. Albeit in varying degrees and timelines, the FED and all other major central banks around the world have been throwing money at the slow economic growth problem, and help push the global debt of all types to $199 trillion, a $57 trillion increase between 2007 and 2014 (Source: Mc Kinsey Global Institute Report 2015).

The approximate $60 trillion increase in global debt since 2007 has been translated in to inflated asset prices, hence the reason for stretched valuations, especially in stocks and real estate.

Are stock valuations in bubble territory? Measured by major US indexes’ price to earnings ratios, no but definitely at the upper end of the range, eerily close to the bubble territory. For stock values to go further up, one of two things need to happen: a) valuations to stretch in to bubble territory, or b) corporate earnings to improve.

For earnings to improve, ultimately the economy has to grow, and 2016 estimates have been lowered to around 2% in 2016 US Gross Domestic Product.

So, with high valuations and slow growth, it is hard to be a champion of robust equity returns, at least on a risk adjusted basis.

There is some good news from the rising or stabilizing energy prices, which many investors use as an indicator of growth and bring new funds to investments as a result.

Other Macro Trends

In macro trends, I see mixed messages in almost everywhere I look.

Take dollar for instance. The 2016 Gross Domestic Product estimates are slashed by major institutions such as the IMF, World Bank and large research firms. One culprit is the strong dollar, which hurts exports. Usually strong dollar lowers inflation and is good for the consumer but input prices being under deflationary pressures, a strong dollar’s current negatives outweigh the positives.

FED action is another area of concern and also full of mixed messages. A sluggish economy is bad news, but allows the FED to move slowly towards its higher interest rate policy. The market is confused on how to read this…an accommodative FED is good, but a slow economy is bad…so…what a man to do?

At the end of the day, albeit slowly, the economy is growing and supports the mildly and cautious bullish outlook in stocks for those who can stomach the volatility that comes with it, as 2016 first half performance being a case in point.

This outlook is probably good for another 6 months, and to be revised after election results…(more on the US elections below).


During a client portfolio review, I found myself saying “…it is not so much the economic risks that worry me, but the political uncertainties.”

Brexit is a case in point.

British establishment politicians, led by Cameron, challenged the Brexiters by offering a simple “yes” or “no” referendum…most likely with a lot of assurances of a “remain” vote.

I speculate this assurance was so convincing, that even the Brexiters themselves thought a “leave” vote would never happen, at least in the short term.

A referendum would just earn good political credits for Nigel Farage and Boris Johnson.

Now, it feels like, the unpredicted result of a “leave” vote is so shocking, and the price tag of its consequences are so high, that it is followed by PM Cameron’s resignation, and winners’ hesitation from declaring victory. Nigel Farage has stepped down from his party and Boris Johnson announced that he wouldn’t run for the PM position.

Now why on earth would a politician do that?

I speculate because they don’t want to go down in the history books as the people who broke the UK, exited the EU and paved the way to an economic and political crisis in their country.

How does all this news affect us?

Other than the immediate shock, the political uncertainty and economic slowdown it will bring to the UK during the drawn out exit process of 2 may be 3 years…not much.

UK contributes only 3% to global economic growth…so a 2-3% drop in their Gross Domestic Product would make financial news for sure, but wouldn’t trigger a global recession.

Scotland and Ireland may leave the UK as they voted to stay in the EU, and that possibility alone may weigh on economic and market performance. But still, it wouldn’t trigger a domino effect leading to a 2008 type of scenario for the same reasons listed above; too small when put in global scale.

Brexit did one thing that might be contrary to some’s intuition; it brought pessimism and weakness, enough to create value and potentially set the stage for the next bull run.

Bad news, followed by panic selling sometimes create the best opportunities…as long as the news doesn’t linger like a bad tooth ache.

The US Presidential Elections

This year’s big whale in the pool is the US presidential elections. Historically, Dow Industrials do significantly better when the incumbent wins. So far, the market has been pricing a Democratic Party (incumbent) victory. So as we approach the election date, the potential for a Republican Party win may trigger a correction to the downside…something to watch for.

Thanks for reading my commentary and as always, you can reach me at for questions and comments.


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