BREXIT--A Sign Of Our Times

The pendulum is swinging toward nationalism and isolationism, not just in Great Britain, but in other  countries as well--Austria, where the Rightist party narrowly lost an election; France, where Marine Le Pen's Rightist party is gaining strength; and in the United States where the "Trump phenomenon" has achieved significant traction.

While few have predicted what's happening,  we really shouldn't be surprised.  For whatever the reasons, free markets and free borders don't seem to be working.  The anger represented by Trump is palpable.

During the latter part of this meager U.S. economic recovery, fiscal stimulus has been thwarted by a deadlocked Congress; thus the reliance on monetary policy alone  to jump start the economy.  Theoretically, the Federal Reserve would keep short-term interest rates at zero (ZIRP), which should inflate assets (equities, fixed income, real estate, art, etc.) resulting in a "trickle down," stimulative  wealth  effect on economic growth.   After seven years of this, those assets have, indeed, inflated; but with limited trickle down effect on the real wages of most employees.  The one percenters are smiling; most everyone else is angry.  "Throw the rascals out!" seems to be the mantra.

As always, there is the counterfactual.  Without ZIRP, it could have been worse, possibly a depression.  It reminds me of the reluctant eulogizer at a funeral who has been asked to say something about the deceased whom he disliked.  His eulogy: "I'll be brief. His brother was worse!"

There is an irony in this.  Recently, average hourly wages have been rising at a higher rate than inflation; so real wages have begun to increase.  In fact, profit margins have begun to shrink--another sign that wages are getting a larger share of the corporate pie.   Perhaps the above-mentioned monetary strategy is working after all; it just took longer.

If business and consumer confidence doesn't wane significantly due to this trend toward nationalism and isolationism, then the  negative impact of Brexit on the Standard and Poor's 500 Index ("the 500"), now at 2037, should be limited, at most, to the technical double bottom at 1810.

If, however,  the current toxic international political climate leads to serious tariffs resulting in restricted global trade, then a recession in the U.S.  would probably occur, resulting in  a bear stock market.  We are in unfamiliar territory, so it is hard to assign a probability to the event of recession.

According to Shiller's CAPE ratio, the 500 Index is currently 52% overvalued.  I continue to hold  30% of my financial assets in no-load equity mutual funds, with the remaining 70% in cash equivalents.  Were a bear market to ensue, I would raise my equity exposure to 70% in two tranches, the first around 1600.  On the upside,  I would rebalance my equity position if the CAPE ratio reached 70% overvalued.

During the next five years, normalization to fair value would result in, at most,  a mid-single digit annual return, inclusive of dividends, for the 500 Index.