Investors Overreact To Brexit Vote

By: Gregory Clay | Sun, Jun 26, 2016
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Market Summary

U.S. equities plunged more than 3% on Friday after the surprise vote by the UK to leave the European Union. The historic vote to leave was not expected by markets and pushed the Dow and S&P 500 into the red for the year. The Dow Industrials fell 610 points, which was its eighth largest one-day loss in history. For the week, the S&P 500 Index finished down 1.6% as did the Blue Chip-heavy Dow Jones Industrial Average. The Nasdaq led indices to the downside off 2% while the small cap Russell 2000 was down over 1.3%.

YTD Performance

A standard chart that we use to help confirm the overall market trend is the Momentum Factor ETF (MTUM) chart. Momentum Factor ETF is an investment that seeks to track the investment results of an index composed of U.S. large- and mid-capitalization stocks exhibiting relatively higher price momentum. This type of momentum fund is considered a reliable proxy for the general stock market trend. We prefer to use the Heikin-Ashi format to display the Momentum Factor ETF. Heikin-Ashi candlestick charts are designed to filter out volatility in an effort to better capture the true trend. Last week's analysis came to fruition when we said "...the market is due for a pause or even a pullback...overbought levels where the market usually stalls out...the recent uptrend has been broken, which backs the analysis suggesting stalling prices..." In the updated chart below stock prices broke below the current trading range. Over the next few days if prices don't bounce back the break-out will be confirmed suggesting the start of a downtrend.

MTUM Daily Chart

You can see in the chart below how after the Brexit vote investors flocked to safe haven assets like the dollar, which surged against other currencies. Treasury prices jump sharply after the Brexit vote. Gold also moved higher with the precious metal rising 1.3% for the week helped by Friday's massive 4.4% spike. Gold's impressive rally Friday offered a taste of what may be in store for the precious metal, as some analysts say it's just a matter of time before prices top $1,500 or even $1,900 an ounce.

UUP Daily Chart


Market Outlook

As we said last week "...Uncertainty about the Fed and Brexit will cap upside movement until there is clarity on both," said Uri Landesman, president of Platinum Partners. Investors are nervous so the market is likely to remain depressed for now, he added..." MarketWatch.com reported how as global markets plunged in the aftermath of the victorious "leave" vote in the U.K.'s referendum on EU membership, investors rapidly adjusted their expectations for the Fed. Markets are now projecting that the central bank won't raise U.S. rates until early 2018. What's more, minorities of fed-funds futures traders are now betting that the U.S. central bank could actually cut interest rates at its next meeting, in July. "We walked in this morning and the probability of a rate cut at any of the upcoming meetings from July to November was at 15%," said Anthony Valeri, investment strategist at LPL Financial.

Britain's decision to exit the European Union in a referendum spread chaos through markets on Friday, but the shock isn't likely to amount to echo the 2008 "Lehman moment" that left the global financial system on the brink of collapse. Britain's Brexit vote does not require the government to pull the trigger immediately because the referendum is not legally binding. And just how long the U.K. might wait has grown as a key tactical debate in the few days since Thursday's vote to leave the trading bloc. For the U.S. economy, the consequences of Brexit should be minimal, but it might not turn out that way. Policy makers and business leaders are subject to overreact to political issues. The real risk of Brexit is that emotion overwhelms fundamental logic, causing one irrational decision to beget another until we really do have the recession or growth slowdown that seemed implausible before the vote. In the chart below investors are trading "risk-off" assets during the current period of market uncertainty.

Quarterly Performance

Put/Call Ratio is the ratio of trading volume of put options to call options. The Put/Call Ratio has long been viewed as an indicator of investor sentiment in the markets. Times where the number of traded call options outpaces the number of traded put options would signal a bullish sentiment, and vice versa. Technical traders have used the Put/Call Ratio for years as an indicator of the market. Most importantly, changes or swings in the ratio are seen as instances of great importance as this is commonly viewed as a change in the tide of overall market sentiment. Put/call ratios have rolled back to sell signals once again. The current ratio indicates traders are extremely bearish after the Brexit vote as they load up on option put contracts to protect against further market declines.

Total Put/Call Ratio

The CBOE Volatility Index (VIX) is known as the market's "fear gauge" because it tracks the expected volatility priced into short-term S&P 500 Index options. When stocks stumble, the uptick in volatility and the demand for index put options tends to drive up the price of options premiums and sends the VIX higher. The chart below confirms how option volatility reflected the market uncertainty as the volatility index rose 32% for the week. The ‘Fear Gauge' broke through the psychological $20 level and settled over $25, which was its highest close since early February. Traditionally, when the VIX climbs above 20, it indicates that investors are on edge. But despite the fear index's surge, it is nowhere near the elevated levels witnessed during the financial crisis of 2008, when the VIX skyrocketed higher than 80, or in the wake of the Sept. 11, 2001, terrorist attacks, when it traded around 40.

VIX Daily Chart

The American Association of Individual Investors (AAII) Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. The current survey result is for the week ending 06/22/2016. The number of individual investors expecting stock prices to rise over the short term is at a four-week low, according to the latest AAII Sentiment Survey. Neutral sentiment rebounded strongly, while pessimism pulled back slightly. Bullish sentiment, expectations that stock prices will rise over the next six months, fell 3.4 percentage points to 22.0%. Optimism was last lower on May 25, 2016. The drop makes this the eighth time in nine weeks that fewer than three out of 10 survey respondents are optimistic. It is also the 33rd consecutive week and the 66th out of the past 68 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, rebounded by 5.7 percentage points to 42.8%. The rise follows last week's four-month low. The increase keeps neutral sentiment above its historical average of 31.0% for the 21st consecutive week. Bearish sentiment, expectations that stock prices will fall over the next six months, declined 2.3 percentage points to 35.2%. The drop follows last week's four-month high, but is small enough to keep pessimism above its historical average of 30.5% on consecutive weeks for just the second time since February.

AAII Sentiment

The National Association of Active Investment Managers (NAAIM) Exposure Index represents the average exposure to US Equity markets reported by NAAIM members. The blue bars depict a two-week moving average of the NAAIM managers' responses. As the name indicates, the NAAIM Exposure Index provides insight into the actual adjustments active risk managers have made to client accounts over the past two weeks. The current survey result is for the week ending 06/22/2016. First-quarter NAAIM exposure index averaged 45.89%. Last week the NAAIM exposure index was 75.96%, and the current week's exposure is 69.35%. The equity exposure index will probably stabilize over the next few weeks as money managers dress up their books for quarterly reporting and reserve funds for the upcoming earning season.

NAAIM Exposure Percent


Trading Strategy

Last week's analysis played out as exactly as advertised where we said "...An article published in MarketWatch.com reported on how the long-anticipated "Brexit" referendum on the U.K.'s membership in the European Union is set for Thursday. Polls released in recent weeks showed gathering support for the "leave" vote, an outcome that many economists say would spark widespread turmoil in global markets and possibly sink the U.K. into a recession...the week after Triple-Witching Day is horrendous. This week has experienced DJIA losses in 23 of the last 26 years with average losses of 1.1%. S&P 500 and NASDAQ have fared slightly better during the week after over the same 25 year span, declining 0.7% and 0.2% respectively on average..." We also said "...If the market does pull back, that might be a good opportunity to "buy the dip" with shares in the leading sectors..." Now the question is where will the market bottom out? The best bet is that investors overreacted to the Brexit vote and stocks will eventually bounce back, especially since some pundits believe there is a possibility the FOMC could lower rates at one of their upcoming meetings. If this prediction comes to fruition the current pullback might be great opportunity to bid on undervalued shares in the Health Care, Consumer Staples and Energy sectors, which are top performers over the past month.

S&P Sector ETF 30-Day Performance

Feel free to contact me with questions,

 


 

Gregory Clay

Author: Gregory Clay

Gregory Clay
Option Strategist
High Value Option Trader
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