Why We'll See Stocks Act Like Bonds and Currencies Soon

The British people powerfully repudiated their political and business elites last week by voting in favor of Britain exiting the deeply flawed European Union (E.U.).

As the Wall Street Journal pointed out, 52% of British voters gave a collective middle finger to all five major political parties, more than 1200 corporate CEOs, and even American President Barack Obama who told them that it would be a terrible mistake to leave the death-clutch of the European bureaucratic state.

This was not only a victory for democracy but a resounding rejection of dismal economic and political leadership that has led the world to the brink of another global financial crisis.

But there's so much more happening beyond the United Kingdom...

Big Losses Are the Price of Complacency

Markets were blindsided by the Brexit vote because investors have lost the ability to think for themselves. Instead of exercising independent judgment and common sense, they listen to corrupt and conflicted advice from Wall Street, politicians and the mainstream press.

They are told that central bankers are doing the right thing by lowering interest rates to zero (or below) and buying back trillions of dollars of government debt (and in the case of Japan, equities).

In fact, these policies are destroying the world.

Furthermore, they are told that if they just keep their mouths shut and allow these catastrophically bad policies to persist, everything will be alright.

Thankfully the British people are no fools and realized that remaining a part of a failing economic and political regime is the path to nowhere.

The sooner investors question the current policy regime rather than rewarding it with near-record stock market prices, the better off the entire world will be.

There will no doubt be disruption and dislocation as the world transitions to a more sustainable path, but delaying the transition will only increase the ultimate pain.

Markets got smashed on Friday after the vote but only after rallying strongly into the vote. On the week, the damage was minimal.

The Dow Jones Industrial Average lost only 274 points or 1.6% on the week to 17,400.75.  The S&P 500 also dropped 1.6% of 34 points to 2037.41.  These losses are child's play. The Nasdaq Composition Index fell 2% to 4707.98, also a chip shot.

Why European Banks Crashed... And Others Likely Will

All three indices are well above their early 2016 lows; the question now is whether they will continue to decline as the ramifications of this historic vote become clearer.

Since there is very little positive occurring in the global economy and markets are already seriously overvalued, it is hard to come up with a case for even more overvalued markets. No doubt central banks will rush to calm investors, but that is like Dr. Kervorkian coming to the rescue.

European markets suffered far larger losses. While the FTSE 100 was only down 3.1%%, the broader FTSE 250 was down 7.2%. The German DAX lost 6.8% and France's CAC-40 dropped 8%.

The most alarming action was found in the European banking system, which is far weaker than its U.S. counterpart.

Deutsche Bank AG (NYSE: DB), which I've been telling people to short all year, fell 14% while BNP Paribas lost 17% and Banco Santander dropped nearly 20%. U.S. banks were hit hard based on the view that rates will stay low for a prolonged period of time and dent profits.

The entire global banking system is under serious stress from low/negative interest rates and a flattening yield curve so the Brexit news hit the sector at a particularly vulnerable time. I would avoid all bank and insurance company stocks until further notice.

One obvious consequence of Britain's vote is that the Federal Reserve will not raise rates until December at the earliest (and probably not for much longer).

Already looking for an excuse to persist in its failed low interest rate policy after last month's horrid jobs report, the vote and subsequent market action gives the Fed the perfect excuse to do nothing for the foreseeable future.

Bond futures are telling us that there is no way the Fed will hike for months and that the next move may be an interest rate reduction, something that is not beyond imagining and would constitute a catastrophic policy error.

What the Fed should be doing is raising rates by 25 basis points every quarter while telling markets that QE is dead. It should then be telling Congress to get its act together and implement pro-growth tax reform and fiscal stimulus, the only policies that have any chance of returning the U.S. to a more robust economic path.

The odds of that happening under the Fed's and Congress's feckless leaders are, unfortunately, zero, which is why markets know better and are pricing in low rates as far as the eye can see.

Investors should be paying careful attention to what bond and currency markets are signaling.

Both of these crucially important markets are trading as though they expect continued economic weakness and political turbulence. On the other hand, until Friday stock markets were trading in a parallel universe in which negative news was ignored. I would bet my bottom dollar on stocks acting more like bonds and currencies rather than the other way around now that the Brits have upset the apple cart.

The most severe reaction to the Brexit vote occurred in currency markets where British sterling plunged to multi-decade lows and the Japanese yen - which is apparently viewed by fools around the world as a safe haven currency - rallied strongly as well.

The euro weakened slightly but is likely to continue to lose value against the U.S. dollar as investors come to realize that the European project is coming apart.

How to Protect Yourself Now

There were calls by politicians around the region for more exit votes as populists exploit growing disdain for the European bureaucratic state and its inability to manage not only economic matters but other important issues such as immigration.

Investors should protect themselves from continuing market turbulence.  They should reduce or hedge equity exposure and ignore the idiotic advice to "buy on the dip" that is being offered by the mainstream financial press - it is the road to ruin.

They should keep buying gold as long-term protection against the likely actions of central banks to keep propping up failing economies.

They should also realize that bonds are essentially certificates of confiscation and avoid them - better to sit in cash and wait.

Remember that most great investors make 80% of their money only 20% of the time, normally when there is blood in the streets.

The blood has only started flowing, but it is just a trickle compared to what may happen if markets adopt a realistic view of an overleveraged, overregulated, poorly governed world.

Michael's big European bank short is up more than 200%, but that's just the beginning of the gains Sure Money readers will see from the world's most dangerous bank as it blows up - and takes the banking sector with it. Click here to get Sure Money yourself and you'll get Michael's investor briefing with details of how to play this short, too.

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About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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