Yes Brexit, Please-We're British

With apologies to the "No Sex, Please-We're British" playwrights, The MoneyLetter's behavioural finance analyst Ken Norquay takes a look at why people make seemingly irrational decisions about investment strategy. His ultimate advice? Look out for number one.

A big round of applause for the United Kingdom! They added zest to an otherwise boring stock market. Their referendum decision to leave the European Union affords us an opportunity to learn about the link between human psychology and the stock market. Let's make a few objective observations about the Brexit phenomenon.

First, Brexit caught everyone off guard. British odds makers were betting that the vote would go to the "remain" side.

Second, the surprise vote was followed by a dramatic increase in volatility of world stock markets, currencies and some commodities prices.

Third, the financial press LOVED IT! Brexit was headline news for days! Excitement! Emotionalism! Forecasts of doom and gloom! Drama! A journalist's delight!

Fourth, WE loved it! We all talked about it, we expressed our opinion, we made bold predictions. The news made us feel vibrant.

However, the passage of time has cooled things off a bit. Volatility has fizzled out, the financial press has moved this story off their front pages and ordinary people have mostly forgotten all about it already.

In Ob-La-Di, Ob-La-Da The Beatles sang: "La-la, how the life goes on".

And now the U.S. presidential nominations will give us more news to get excited about. Then, the actual election . . . ("La-la, how the life goes on").

Long-term impact?

Do events like Brexit have any long-term effect on financial markets? Of course they do. Are those effects predictable? Not as predictable as we'd like to think.

My mentor, Robert Farrell, used to write about the cover stories of major U.S. news magazines as reflections of market psychology. He observed that at stock market tops, news magazines featured positive economic cover stories; and at bottoms, the same magazines featured cover stories of gloom and doom. He used this observation as a contrary indicator.

When we apply Farrell's contrary-opinion approach to the Brexit story, it looks like something is wrong. We are seeing a spate of gloom and doom stories at a time when the S&P 500 Index rose within 1 per cent of its all-time high. Does this mean my thesis that the stock market peaked in May 2015 is wrong? Are these pessimistic stories of the breakup of the European Union and of the United Kingdom itself proof that the bull market is continuing?

For clarity: Part of the theory of contrary opinion states that an up trending stock market "climbs a wall of worry". This means the market goes up AND the financial press reports gloom and doom stories, simultaneously. At that stage of a long term up trend, skepticism continues and the up trend continues. When the skepticism turns to optimism, the market peaks.

Important question: Is the negative press associated with Brexit a bullish sign? Should we re-purchase the stocks or mutual funds we sold in the past year? Is the U.S. stock market still in an up trend, climbing a wall of worry?

When in doubt, check the facts

It's time for a reality check. Is the U.S. stock market currently in a long-term down trend as I have been reporting, or is the up trend that began in 2009 continuing, as so many mutual funds sales people are saying?

The day before the surprise Brexit referendum results, the S&P 500 Index hit 2113, falling short of the May 2015 high by only 1 per cent. This means the action of the U.S. stock market over the past 13 months has been trendless: neither an up trend nor a downtrend.

Long-term U.S. interest rates as measured by the yield of 20-year+ U.S. treasury bonds dropped to a slightly lower level than the February 2015 low. (That "pop" to new lows came right after the Brexit surprise.) No downtrend or up trend there. Same for Canada: interest rates are almost exactly the same as they were at their bottom at the end of January 2015.

Our counter-cyclical model had said that U.S. interest rates bottomed in early February 2015, followed by a stock market peak in May 2015, heralding the start of a long-term decline in U.S. stock prices: the beginning of a bear market. Brexit gloom and doom stories, combined with "no-trend" interest rates and the no-trend stock market call this bearish interpretation into question. Has this analyst been over-cautious?

The price of gold erupted to a new short-term high following the surprise news, confirming our view that gold prices reversed from a downtrend to an up trend in December 2015 at $1,045 U.S. per ounce. This view has been confirmed by the recent emotional surge in the price of gold.

The U.S. dollar measured against "the basket" of non-U.S. currencies has been trendless since March 2015; it is currently about half way between the highs and the lows of this 16-month trading range.

The Canadian dollar is still in a short-term up trend within a long-term down trend versus the U.S. Dollar. The same can be said for the price of oil. Canada's loonie has become a petro currency, rising and falling in sync with the price of oil.

The Toronto stock market's down trend began in September 2014 and is currently still 10 per cent below that high.

Investment strategy: What to do?

Our basic investment strategy involves owning investments that are in long-term up trends and not owning investments in long-term down trends. My analysis is geared toward helping people decide what investments to buy and sell based on long-term trends.

Clearly we can invest in the precious metals at this time. Gold is in an up trend. Mutual funds that invest in precious metals, not mining stocks, will follow gold's long-term trend: currently this trend is UP. Mutual funds that invest in mining stocks are the tricky ones. Gold mining stocks correlate to the price of gold and to the direction of the stock market. I recommend that traders continue to use Canadian gold mining stocks as trading vehicles - particularly the five specific stocks I named in my last two MoneyLetter articles.

The U.S. stock market has gone sideways for over a year - neither an uptrend nor a downtrend. Canadian investors need to look at two trends when they invest in U.S. stocks: the U.S. stock market and the Canadian dollar. Currently the U.S. stock market is trendless, and the loonie is in a down trend. Investing in U.S. stocks is not prudent for Canadians.

The Canadian stock market is still in a downtrend. Canadians who have owned stocks since the top in September 2014 have lost a modest amount of money. At this time there is no reason to invest in Canadian stocks unless you are a short-term trader.

Investing in bonds is tricky too. The U.S. bond market is back where it was 17 months ago: neither in an uptrend nor a downtrend. The same is true for the Canadian bond market. Long-term interest rates are trendless. Bonds are trendless. Keep your expectations in line with this boring reality.

When will the stock market investor's green light come on?

Bullish scenario: Let's imagine that this liquidity-driven stock market continues up as the bulls forecast. Let's imagine that the thirteen-month "correction" they refer to is over. What should we expect to see?

1. Continuing negative economic news.

2. The U.S. market will surge 5% to 10%, then cool back down.

3. After the cool down, prices will start to rise again. That's when we buy.

Bearish Scenario: Let's imagine that the market quickly drops like it did in summer 2015 and winter 2016. If it drops decisively below the lowest level of January 2016 (S&P 500 Index at 1,800), the U.S. market would have formed a so-called "double top." This occurrence would confirm our thesis that the U.S. market is in a serious long-term downtrend. If the S&P500 holds above 1,800, it would reinforce the bull's opinion, and would be a buy point for traders and speculators.

What's the lesson in all this? Imagine what might have happened if our Canadian referendums had turned out differently. Imagine if Quebec had voted for "Quebexit". What would Canada look like under this scenario? What would your RRSP look like?

We do not live in a safe, secure world: the word "securities" is not an accurate description of what is bought and sold in the stock market. Next time you sing "O Canada", sing "I stand on guard for me". That's the lesson.

Ken Norquay is a Chartered Market Technician (CMT) and is the author of the book Beyond the Bull, which discusses the impact of your personality on your long-term investments: behavioural finance.