Last week, Brexit happened. England voted to leave the European Union, Britain Exits, Brexit. David Cameron, Britain’s Prime Minister, also steps down. So what does Brexit mean to Americans exactly. Not Wall Street, but everyday working Americans? The reaction from the world markets tell a bigger story about what Brexit means to the world, but what does it mean to you and me, and thats what we are here to talk about.
Britain woke up Saturday with a Brexit Hangover asking “What have we done?”
Over the weekend over 3 Million people are reported to have signed an online petition to reverse the Brexit vote, but is that really going to happen. Even if it did, will that reverse the chain of events in the world financial markets? And will it change anything for us in the United States?
The reality is the entire world economy has been hanging by a thread. Greece’s over spending the United States over spending, and all of it supported by two things. Cheap oil and cheap money.
After peaking at over $100 per barrel, Oil fell to just over $20 per barrel. Thats an 80% drop. Keep in mind that to go back to $100 a barrel is a 500% increase. Yup that’s financial math for you.
So when you hear the big “gurus” screaming about an 80% drop in the stock market, is it possible? Well first lets look at interest rates.
A big thread holding the world economy together has been cheap money in the form of low interest rates. Taking a little trip back in time and looking at the last four years of the Carter Administration, we saw rates push north of 20%. Can you imagine your house payment on a 21% Mortgage? Yes it happened in 1980. These high interest rates and high inflation led to a new term, stagflation. This is a combination of double digit inflation and double digit interest rates. The theory is that raising rates reduces spending. What we learned is that raising rates raises the costs of goods and thus raises prices.
When prices go up, consumers and the talking heads on the news call this “inflation”. In pure economic terms it is simply price increases. Politicians have spun the terms so they could print money and not have to be responsible for inflation as Obama has done. Over time though, printing too much money also causes price increases because of inflation of the money supply. That is where the term inflation comes from.
The reality is people stop spending which reduces the demand for goods, I mean how much more stuff do you really need? The world economy is driven by making more stuff for more people. When the people can’t buy, the economy slows. Giving away free money with 1% interest rates works for a while, but eventually, investors want their money. Without investors there are no companies to make all that stuff in the first place. Politics always loses to investors in the long run. The Reagan administration worked with the markets instead of against them leading to the recovery period during his second term.
Ok so what is going on and what does it mean to me?
When the stock market tumbles, what the big investment houses are saying is they want to make more money on their investments and they think interest rates are going up or should go up. When you borrow money at 1% interest and invest it in a “Dividend King” like Johnson and Johnson which was recently paying a 3% dividend, you are making a return of three times your cost of money on someone else’s money.
If interest rates go to 2%, and the markets want that same triple profit, then they demand 6% from their investments, the price of Johnson and Johnson has to drop 50% to make that happen or Johnson and Johnson has to increase sales and profits to cover the difference. That is why some people are saying that an 80% stock market drop is possible. Just 5% interest rates would drive the big investors to demand such high returns that the market could drop 80%.
Do I expect to see a 50% or even 80% drop in the stock market? No. Is it possible, Yes. Many market makers are saying that we are in a bubble and a drop is imminent. Brexit. My bet is that we will see a triple storm over the next twenty four to forty eight months. First interest rates will start to go up. Second inflation will finally come out of hiding and third the stock and housing markets are going to slide.
Going back to the chart above and looking at interest rates from 1976 to 1986, and also House prices during the same period. In 1976 the Median new home price in the US was just $41,600. With double digit interest rates in 1986 the median price more than doubled to $118,900. Over the next ten years, they only rose about 24% to a median price of $156,600. Keep in mind there was a huge housing bubble in the middle of this, anyone remember the Resolution Trust Company and the Savings and Loan failures? The 2006 bubble is the biggie. From 1996 to 2006, the median new home price rose to $314,000, again doubling the value of a home in just 10 years.
Now here is the weird one. in 2016, home prices are exactly the same! This is a key piece of information to understanding how Brexit will impact the US.
The key patterns here are rising interest rates and rising home prices and inflation. All at the same time. You might be thinking “sell” when you look at this, but you would be on the losing end. With interest rates rising so fast, even though a house might cost twenty five thousand less in six months, the payment could be a thousand dollars a month higher. My bet is the housing market will remain stagnant, and as interest rates go up, building new homes will go down and that will raise the prices of both new and existing homes.
From 1970 to 1980 the stock market was considered a “bear market” it was relatively flat. Even the 1987 “Black Monday Crash” was followed by a slow decrease in stock prices for a few years. Over time the markets recovered and led to the crazy bull run we have been riding since 2009.
And that brings us to Brexit and the world markets.
We all know there is no free lunch. Any time we give something away, someone has to pay for it. Those truly rich people we expect to help pay for Obama care, free college and other socialistic programs all find a way to keep the money away from the tax man. Even Apple computer is in on the game.
The markets reaction to Brexit wasn’t at all about Brexit. Brexit was simply an event that got someone looking at that little tiny thread that is holding the world economies in check. When they looked close they realized that the thread had fewer strands than they thought and Brexit just cut one of them.
So will revoting and canceling the Brexit put that one economic thread back and fix the markets?
I don’t think so, and I think it is safe to say, the world has seen how thin the thread is and it is time to buy some rope to fix it.
I think the new rope required for the world economy is going to be higher oil prices, higher interest rates, a running bear market and slowing the housing market. In the long run, if you have good companies in your portfolio, and a good mortgage on your house, you will be fine. Don’t let Chicken Little ruin your day.
Me, I am going surfing now…
Scott Bourquin is the host and creator of Tech-Tach-Dough, a talk show about technology, fast toys and money. Look for the shows coming online soon at TechTachDough.com