Biggest Market Decline Ever?

That’s a title that gets attention and raises blood pressure, and it’s been the lead story for too many news outlets today. The stock market has experienced a lousy few days, without question. But the media talk is misleading, and the recent results warrant reframing. 

Many headlines cited today’s point drop in the Dow Jones Industrial Average, rather than its percentage drop. The Dow fell 1,175 points — a nasty outcome, and its largest point drop ever. But on a more meaningful percentage basis, the Dow was down 4.6% — a hardly comforting result, but only its 108th-largest percentage drop since 1900. That’s far-less-startling than “biggest market decline ever”. 

After today’s drop, the market is down 7% since mid-day Wednesday (1/31) — a terrible three-day run. But a glimpse at the last forty years of global stock market declines is instructive. As Figure 1 below shows, the largest decline within each year (represented by the orange dots) has been at least 12% in more than half of the years since 1979. And in 20 of the last 21 years, global stocks experienced intra-year declines of 7% or more, with 2017 being the sole exception. Interestingly, in most years with significant intra-year declines, the market still ended with a positive calendar-year return.

Figure 1 — Significant Market Declines Are Common

Figure 1 — Significant Market Declines Are Common

Despite their definitive claims to the contrary, neither journalists nor analysts know why markets rise or fall. Today, counterintuitively, most point to an accelerating economy as the problem. They argue that such momentum could cause central banks to raise interest rates and, in turn, economic growth to slow. Such a view is not new or shocking, so we don’t find it sufficient as an explanation for the market drop.

More likely, a few mildly surprising news items were the proverbial straws that broke the camel’s back. Or maybe the period since the 2016 presidential election was a bit too perfect — with the U.S. market up over 30% in just 15 months, without a single month of market loss. Or maybe, with an even wider view, the period since the bottom of the global financial crisis in March 2009 was finally a bit too much — with the U.S. market up nearly five-fold since, or nearly 20% per year for nine years! But, who really knows. We certainly don’t.

We are not unconcerned, as you know. We worry about demographic trends, productivity woes, corporate-profit margins, stock-market valuations, inflation, the Euro, global debt levels, Chinese growth prospects, artificial intelligence, and asteroid strikes.

But neither our level of concern nor our outlook has changed from two months ago, when the current stock market level was last encountered. The last time around, way back in the first week of December, the current level of stocks was seen with exuberance — global growth was accelerating, tax reductions were to drive corporate profits higher, and tax incentives were to accelerate corporate investment and economic growth. Today, just 40 trading days later, this same level of stocks is seen with panic — economic growth may accelerate, and interest rates may increase. However, at both points, we have maintained the same market outlook for the same market level: 10-year expectations for global stocks well below historical-averages, but still above 10-year expectations of global bonds, which sit near 5,000-year-low yields. 

So, for anyone with a long time horizon, exposure to stocks is warranted, despite the anxieties we have discussed for several years. And since your bonds are liquid and your allocation to stocks is at or below normal levels, you are prepared to take advantage of attractive market levels, should they arrive. At the moment, while we are far from excited about stocks in general, we are aggressively considering several individual stocks that have recently piqued our interest. Stay tuned.

In the meantime, we recommend looking far out on the horizon. It’s calmer out there. 

No-Body

No one has successfully predicted stock-market results over the short term (any period less than a few years). No one. No investment legends from Omaha. No university endowments from Boston. No hedge funds from Greenwich. No prodigies, no sorcerers, no alchemists. No-body.

We have investigated. Lists of wealthiest Americans include no one magically inclined. Lists of top-performing funds show no one mystically gifted. Papers by idealistic academics and research by pragmatic practitioners find no one psychically skilled.

And yet, despite an absence of short-term fortunetellers, short-term forecasts remain prolific. In fact, we cannot find a single financial institution (of size) without a 2018 outlook on offer.

Morgan Stanley says global economies will “skate in sync”. RBC is feeling optimistic but vigilant. T. Rowe Price is simply optimistic. B of A Merrill knows we are toward the end of a bull market, but also knows such periods can provide great returns. Goldman predicts an impressively precise S&P 500 level of 2850. If you search on “stock market prediction 2018”, there are 8.56 million results.

All of these forecasts – all of them – lack evidence of predictive power. But they are also packed with elegant explanation. It is this combination – the futility of the forecasts and the intelligence of the forecasters – that makes one wonder why the forecasts persist.

A Freudian might argue that financial forecasters see in their mirrors market wizards. Most of them would, at least in private, acknowledge the difficulty of short-term market prediction. But (nearly) all of them still see themselves as especially skilled exceptions. After all, they are invariably well pedigreed: Well educated, well employed, well spoken. Some even write books, give speeches, appear on television. A presumption of special powers — by both investors and the forecasters themselves – seems reasonable.

A cynic might argue that financial firms wave their wands to enrich only themselves. Robert Proctor, Professor of the History of Science at Stanford, coined the term “agnogenesis” – the intentional cultivation of ignorance in order to sell a product. Proctor says that some industries and companies – think tobacco and Merck[1] – deliberately foster our confusion to enhance their profits. In the financial industry, the ever-complex, ever-changing clairvoyance of experts invokes much greed and more fear. In turn, billions in trading commissions and fees are generated. Suspicion is hardly unreasonable.

And investors are worried and overwhelmed. In the face of financial anxiety and complexity, the natural inclination is to swallow any plausible potion on offer. Our human brains demand order, and we attempt to satisfy this by relying on the experts.   

But when it comes to short-term market expertise, we find none. Any short-term advice, however mesmerizing, must be avoided, whatever the cause or motive.  It is difficult to acknowledge that the short term is random, but it is dangerous to deny reality.

J.K. Rowling says, in creating a fantasy world, the most important thing to decide is what your characters CAN’T do. In our perfectly un-fantastical world, short-term market results CAN’T be forecast, by anyone.

Instead, we advocate an unwavering focus on the long term. It doesn’t eliminate all worry or complication, and it doesn’t provide certainty. But while we find no evidence of market predictability in the short run, we see all sorts of evidence of solid predictability in the long run. And where one can find predictability, one can find investment success, and calm.

 

[1]Arenson, Karen. " What Organizations Don’t Want to Know Can Hurt." New York Times, August 22, 2006, Business Day

Amazon!

“How Amazon is Dismantling Retail” is a great video. It’s startling, even despite the self-evident trends in the retail sector.

Below are a few U.S. retail and Amazon notes (from the video and elsewhere):

  • The number of malls in the U.S. grew more than twice as fast as the population between 1970 and 2015.
     
  • The number of mall visits in the U.S. was 35 million in 2010. Just three years later, this dropped by more than 50%, to 17 million. It is likely that future mall-visit data will confirm that this trend has continued or even accelerated.
     
  • The combined stock market value of Wal-Mart, Target, Best Buy, Macy’s, Kohl’s, Nordstrom, JC Penney, and Sears is $307 billion. The stock market value of Amazon is $481 billion.
     
  • 49% of American households own a landline. 51% attend church monthly. 52% have an Amazon Prime subscription.
     
  • Amazon plans to open 418 fulfillment centers through 2020, on a base of approximately 50 U.S. centers now. Amazon fulfillment centers will create approximately 40,000 full-time U.S. jobs in 2017.
     
  • Amazon started with books, but its reach has obviously broadened dramatically. It is likely to become the largest apparel retailer in the U.S. this year. (Amazon bought Zappos in 2009.) It delivers random supplies to STUDIO within two hours, with no delivery charge. And there remain lots of retail (and distribution) segments in its path.
     
  • Amazon recently entered the $50 billion aftermarket auto-parts business, competing with AutoZone, O’Reilly’s, Advanced Auto Parts, and Genuine Parts. We always viewed this retailing niche as unusually attractive, due to its combination of retailing and wholesaling. But Amazon has made deals with the largest parts suppliers in the world in recent months, and it is coming!
     
  • We are usually skeptical of any company’s ability to enter an already-competitive space. In the case of Amazon’s entrances into new markets, we tend to be skeptical of the future of the incumbents. Jefferies reports that Amazon is now offering same-day delivery for auto parts in 40 major U.S. cities at prices that average 23% less than the incumbents, despite having entered the market just last year. We predict still more retail space coming available across America soon.
     
  • The even-larger industrial-supply market was newly added to the Amazon menu — beware W.W. Grainger, MSC Industrial, Fastenal, and lots of mom-and-pops. “Amazon Business,” just $1 billion in annual revenue a year ago, is reported to be growing 20% month-on-month. That is, the entire business is 20% larger each month, not each year. 
     
  • Many think of Amazon as only a web retailer, but it also has within it an incredibly valuable technology company. Amazon Web Services (AWS) provides cloud-based storage, networking, and other web services which allow customers to scale their technology more quickly and less expensively than they could on their own. AWS has over one million customers, including Netflix, NASA, and the CIA. AWS generated $3.1 billion in operating profit in 2016 — 75% of the operating profits of the entire company, despite representing just 10% of company revenue. 
     
  • Amazon had $136 billion in revenue, but just $2 billion in net profit, in 2016. However, the company is investing heavily in its business at the moment, preparing its already-enormous operations for a still-much-larger revenue level. If the company were content with its current revenue level, it could operate with a much smaller level of expenses. Under this scenario, we estimate that Amazon’s profits would be at least $10 billion, or five times the current level. This perspective allows a glimpse into Amazon’s long-term profit potential.
     
  • While Amazon’s financial outlook is phenomenal, the market is expecting phenomenal, or more. Amazon’s stock market value is $481 billion, which makes it the fifth most valuable company in the world. The stock trades for 203 times last year’s profit (or earnings) per share. For comparison, the S&P 500 (an index comprised of 500 large American companies) trades at 25 times last year’s earnings, a level well above its historic average. 
     
  • Amazon came public 20 years ago last week. Since its IPO, the stock has increased 65,000%. That is, a $10,000 investment would have become $6.5 million. Over the same period, an investment in the S&P 500 would have become $29,000.
     
  • It’s tempting to see Amazon’s progress as obvious in hindsight. But between 1999 and 2001, Amazon’s shares lost 95% of their value. Even the best investors with the longest horizons would have trouble holding the stock through such a period.
     
  • And despite a 15-fold increase in Amazon’s revenue from 1999 to 2009 ($1.6 billion to $24.5 billion), there was no increase in the Amazon share price over much of the same period. In 1999, the market had some wildly aggressive expectations for lots of companies. It is critical to remember that the market’s expectations for a stock ALWAYS matter, no matter how good the business.

In 1982, Sears was America’s largest retailer. Nine years later, its annual revenue was half of Wal-Mart’s. While we make no parallel prediction for Wal-Mart’s imminent demise, we did sell all our shares earlier this week. We no longer like the risk/reward ratio, mainly due to increases in the numerator, driven by Amazon.

We believe Amazon will be the most valuable company in the world, possibly by a large margin, at some point in the next decade. Unfortunately, the range of outcomes is so wide and the level of expectations so high that, at the current share price, we don’t like the stock as much as the business. We would love to be a shareholder, but, even with Amazon, the price still must be right.

Short Note: A Dominant Few

As observed in the table below, the S&P 500 has been dominated by just a few stocks in 2017. Through the end of last week, Apple alone was responsible for 13% of the market’s return. The top five contributors accounted for more than one-third of the market’s return. And the top ten contributors — representing just two percent of the 500 companies in the index —contributed nearly one-half of the return.

A robust market this has not been.

Source: Whitney Tilson

Source: Whitney Tilson

Short Note: Care for a Netflix Bond?

Netflix recently raised 1.3 billion euros in a massively oversubscribed bond offering. It was priced to yield all of 3.625%. And the company promised to pay that generous annual rate — one percent more than the corresponding U.S. Treasury note — for the next decade. To summarize the calculus, a buyer of the Netflix bonds will earn something between negative 100% and positive 3.625%.

Netflix only burnt through $1.8 billion in cash in the 12 months ended 3/31. It only has $20 billion in contractual obligations — $5 billion in debt and $15 billion in “streaming content obligations.” Eight of the $15 billion in streaming content obligations are found nowhere on the company’s balance sheet because they “do not meet the criteria for liability recognition.” There is also a bit of competition on the way.

What could go wrong? 

On Forecasting, and the Recent Bond Rout

It is dangerous to make forecasts, especially about the future. 

— Mark Twain

Much of our work is forecasting. We weigh the prospective returns and risks for stocks and bonds. We consider your tolerance and capacity for the next market downturn. And, most importantly, we analyze the likelihood that you will have enough money during your lifetime.

Unfortunately, most of us humans are not naturally built for good forecasting. We identify patterns everywhere, though such explanations are often illusions. We see recent trends as predictive of the future, though the opposite is often the case. And we anchor on initial beliefs, though radical adjustment is often more appropriate.

As far back as I can remember, my grandfather cursed Jerry Taft, the weather forecaster from Chicago’s NBC affiliate. According to Grandpa, it rained all too often when poor old Jerry said “it wouldn’t” rain. Somehow, Grandpa decided that when Jerry said the odds of rain were less than 50%, he meant that it wouldn’t rain — no chance. Of course, Jerry was regularly wrong in the other direction too. Such errors negatively affected Grandpa’s golf game. They were damning offenses that put Jerry’s eternal future in peril.

The recent Presidential election saw similar analysis. It’s become common knowledge that anyone who professionally predicted the election outcome in favor of Secretary Clinton was obviously “wrong”. A competitor of ours said the following: 

Nate Silver, the High Priest of Election Models and founder of the FiveThirtyEight blog, won thedistinction of being the least wrong in predicting the outcome. [Silver’s final forecast showed Clinton with a 71% chance of winning the election.] Although he continually warned us that he might be wrong, his clear implication was that Hillary would win. …These are a lot of high-powered minds with deep understandings of statistics and modeling but they were all – to quote The Donald – Wrong!

The single most important aspect of forecasting is a probabilistic mindset. Sometimes, Jerry said there was only a 10% chance of rain, yet it would rain. Many, including Grandpa and our unnamed competitor, would say that Jerry was “Wrong!” on those days. But when Jerry said there was a 10% chance of rain, he didn’t mean 0%. He meant that if tomorrow were to occur 100 times, based on what we know today, he would expect rain on 10 of those tomorrows. Sometimes, it’s not that the forecast is wrong, but simply that the unexpected occurs. 

Our competitor went on to say the following:

But the 2016 election was a one-time event. Trump won 100% of the election and Hillary lost 100% of it. 

That’s the thing about the future — it’s uncertain, and more things can happen than will happen. Yes, tomorrow will only happen one time. Yes, good forecasters must constantly strive for improvements in their always-imperfect models. Yes, good forecasters must constantly work to improve their only-human judgment. And, yes, these realities can be most unsatisfying at times. In fact, it may feel good to blame the forecaster for an undesired outcome, but blame tends to exceed blameworthiness by a rather large factor, and it fails to shed useful light.

The future and certainty will forever share little. Probabilistic thinking, however imperfect it may be, is the only logical framework for analysis of what lies ahead. 
 

If you really don’t want to get wet, you need to have an umbrella every day that the chance of rain is greater than 0%. Since we find nearly all 0% (and 100%) forecasts to be wildly overconfident, we would recommend an umbrella on 0% days as well. But if you find carrying an umbrella to be a literally too-heavy burden, then you must necessarily accept the risk of getting wet, or maybe even soaked. 

In the case of the bond market, we have chosen to carry a sturdy but refreshingly lightweight umbrella for several years. It’s not that we necessarily forecast that interest rates would go up (and bonds down). We simply believed that there was so little to be gained, and potentially so much to be lost, by trying to eke out a slightly higher yield in longer-maturity or riskier bonds. Because we don’t know anyone who invests in conservative bonds primarily for capital appreciation. For most, bonds are intended to either maintain an already sufficient standard of living or, more commonly, cushion potential losses in stocks. 

In recent months, the market has begun to anticipate rising inflation and, as a result, rising interest rates. Just 90 days ago, the 10-year Treasury note yielded 1.5%. Just two weeks ago (the day before the election), it yielded 1.8% per year. Today, it yields 2.3%. That marks a 53% increase in yield in the last three months, and the biggest two-week jump in 15 years. 

While interest rates have increased by less than 0.8% over the last three months, the global bond market (i.e., the Barclays Global Aggregate Index) has quietly slipped 7%. In contrast, STUDIO’s bond portfolio* has been flat over the same period. Now imagine what might happen to global bond prices if 10-year Treasury bond yields continue increasing toward a more historically normal 6%-ish level. For many, their bonds may cause a pain they are not anticipating.

Again, we encourage ownership of bonds not for their appreciation potential but instead for the security they can provide a stock portfolio. We do not believe bond portfolios are an appropriate place to seek return maximization, nor do we evaluate the success of your bonds in relation to the overall bond market. Instead, we purchase bonds with the aim of providing some level of positive return over the long term, while partially insulating stock portfolios from major downturns. 

We believe the recent steadiness of STUDIO’s bond portfolio was driven by its short-maturity orientation (i.e., nearly all bonds mature in less than three years) and its inflation-protection exposure (through U.S. Treasury Inflation Protected Securities (TIPS)). We anticipate these attributes will dominate your bond portfolio for some time to come, and, while nothing about the future is certain, we believe they will continue to provide the buffer we seek.

Probabilities are not always comforting. We’d rather be sure when it will rain. We’d rather be sure who will win the election. And we’d definitely rather be sure that we won’t run out of money. Since the future doesn’t allow us the sureness we prefer, thinking in probabilities is still the best approach to forecasting and making decisions.

By the way, Jerry Taft is still on the air in Chicago, making useful forecasts every night. I suspect Nate Silver will be around for a while yet too. And may your bonds continue to offer the protection we expect.

We hope everyone had a Happy Thanksgiving.


STUDIO's View of the 2016 Presidential Election

The presidential-election result was a significant surprise to most of us, and to the markets. Late last night, S&P 500 futures (which trade overnight) were down five percent from yesterday’s close. Today, the market erased those losses and actually finished up one percent from yesterday’s close. Clearly, the market is unsettled about the consequences of a Trump presidency.

We expect continued market uncertainty and volatility in the months ahead. The outlook for much lower tax rates represents a significant but unpredictable shift in the federal budget and U.S. Treasury bond yields. The prospect of detaining and deporting large numbers of undocumented immigrants is nearly certain to fray market nerves. The uncertainty regarding our involvement in longstanding international organizations, including NATO, the IMF, and the World Bank, will cause worry. And concern that Mr. Trump may be partial to a less independent Federal Reserve may be destabilizing to markets. 

While these and other concerns are all worthy of close attention, we believe they likely will not impact the multi-decade path of corporate fundamentals, which is ultimately responsible for the long-term path of stock prices.

However, Mr. Trump’s plans for our international trade agreements could have a more lasting impact. If trade relations were damaged or existing deals abandoned, there are two potential long-term and fundamental consequences for U.S. corporations: 1) less revenue growth, resulting from less trade with foreign partners; and 2) lower corporate profits, resulting from both lower revenue levels and greater labor costs. Currently, our expected return for U.S. stocks is little changed from yesterday, but the outlook for trade deals represent the long-term market risk we will be watching most closely.

There is also a series of important referendums and elections in Europe over the next year. According to (potentially understated) polls, the frustration across the Atlantic seems similar but even louder than that evidenced in our election, with stakes at least as large. We expect volatility to be a dominant part of our experience for some time.

Despite our worries, we firmly believe that the physics of corporate fundamentals will overwhelm all perceived and real worries in the long run. Even depressions are endured and wars fought, but good American businesses grow over time. It has been said that our fears are always more numerous than our dangers — a valuable perspective for times of financial uncertainty.


STUDIO's View of Brexit

Yesterday, the British people made the decision to exit, or “Brexit” (a British exit), the European Union (EU), likely their most important decision in a generation. The vote was close, with 52% voting to leave and 48% to remain. Prime Minister David Cameron has since announced he will resign by October; he campaigned strongly for the Remain Side, arguing that an exit would reduce economic growth, trigger a recession, and result in a long period of instability for the economy, trade, and jobs.

While the intellectual argument of the Leave Side focused on British sovereignty and burdensome EU regulation, the emotional argument focused on what it deemed uncontrolled immigration and the resulting risks of crime and terrorism. The emotional case seemed to gain significant momentum as the vote approached.

Britain’s exit is a big hit to the EU, which is already dealing with slow population growth, low productivity growth, large debt levels, high unemployment, a migrant crisis, the Ukranian conflict, and lots of cross-border squabbling. Most of all, Brexit creates more risk that other EU countries may hold similar referendums.

Yesterday’s financial markets did not expect or like the vote: U.K. stocks were down 3.8%, European stocks were down 6.9%, and U.S. stocks were down 3.6%. The British Pound fell 8.1% against the dollar and sits at its lowest level in 30 years. The euro fell 2.4% against the dollar.

Despite yesterday’s market reaction, we believe the long-term impact to your portfolio will be minimal. Any reduction in our European stock-market expectations will be small, and those changes will be muted by your portfolio’s non-European-stock-market emphasis and bond exposure. With a little luck, the current volatility might even present us with an opportunity to add a new, attractively priced security to your portfolio.

EU and the U.K.

Since World War II and the devastation of much of Europe, a series of treaties led to a more integrated, less war-prone Europe. In 1951, The Treaty of Paris created The European Coal and Steel Community (ECSC), which launched the movement and brought sharing of the production of coal and steel, two primary resources during the war, between France and Germany, two primary enemies during the war.

At least 10 subsequent treaties and acts have wound from the ECSC toward the European Union (EU). The EU was a union of 29 member countries covering over 500 million people, providing a single market ensuring the free movement of people, goods, services, and capital.

Today’s EU is the same, less the U.K. It is the first country to leave the EU, and the repercussions are uncertain.

According to the World Bank, the total Gross Domestic Product (GDP, or the total value of goods and services produced within a region) of the EU was $18 trillion in 2014, compared with $17 trillion for the U.S. The U.K. was the second-largest economy in the EU (behind Germany) and fifth-largest in the world, at approximately 17% of EU GDP. (For comparison, California was roughly 15% of U.S. GDP). And as can be seen in Figure 1 below, exports to the EU are quite important to the U.K., and vice-versa.

Figure 1

Figure 1

“Leave Side”, Immigration

Despite the obvious financial interdependence of the U.K. and the EU, the risk of reduced long-term economic growth, and the near-term uncertainties caused by the exit, 52% of Brits voted to leave the EU. They point to Norway and Switzerland as successful examples outside the EU. However, among many other economic and cultural differences, the population of the U.K. is 64 million, many times the eight million for Switzerland and five million for Norway. And leaving the EU is altogether different than simply operating outside of it.

The Leave Side’s campaign clearly identified immigration as a key source of frustration and worry (see Figure 2 below) among Brits. Many were convinced that leaving was the only way for the U.K. to control immigration, since the free movement of the bloc's citizens is a basic tenet of EU law.

In 2004, the EU added eight Eastern European countries, triggering a surge of immigration from those countries, due to higher unemployment and strained public services. Since then, the percentage of foreign-born residents in the U.K. has doubled, to 13% of the population. Britain’s relatively attractive economic growth rate, which has been twice the level of the euro zone (i.e., a 19-country subset of the EU that adopted the euro as its currency), has drawn many looking for work.

Figure 2

Figure 2

Net migration to Britain in 2015 was 330,000 people, the largest level since 2005, the year after Poland and other Eastern states joined the EU. According to EU rules, there was no way to limit most of the influx. And despite a belief by some that immigration provided a net economic benefit, others felt that British identity and jobs were at risk.

Additionally, in the “Vote Leave” campaign’s official leaflet, a map showed how the prospect of Turkish membership would create an EU border with Syria, Iraq, and Iran. This seemed to imply both a concern over the inclusion of Turkey, a country of 75 million with a 97%-Muslim population, as well as concern over a border-driven vulnerability to radical terrorism, heavily impacted by the Syrian-refugee debate.

 

Exit Repercussions

There is no comparable precedent for Brexit. As HSBC Chairman Douglas Flint said, “We are today entering a new era for Britain and British business. The work to establish fresh terms of trade with our European and global partners will be complex and time consuming.”

Upon its exit, the U.K. will forfeit the favorable trade terms that EU membership offers. While we have seen a wide range of numbers from various sources, the International Monetary Fund (IMF) projects that U.K. GDP could drop between one percent and four percent by 2021, depending on the policies adopted. While this would be a lousy five-year outcome with lots of employment and other consequences, a flattish economy is quite far from a depression.

Prior to the vote, Goldman Sachs, JPMorgan Chase, and HSBC all warned that a Brexit could cause them to move thousands of jobs out of the U.K. In the case of JPMorgan Chase, the company specifically referenced the prospect of moving 25% of its 16,000-member U.K. workforce. It appears banks in the U.K. may lose their “passporting” rights, which will force firms that wish to access EU markets to move their operations within those markets. As a result, the status of London as one of the world’s top financial centers is at some risk.

There are many similar examples. British airlines currently have the freedom to fly within and between EU countries, thanks to an existing agreement with the EU. Last night’s outcome may mean the U.K. will lose these freedoms if new contracts are not put into place. In the long term, airlines may consider replacing London with another European city as an entry point into Europe and could also make flying into and out of the U.K. more expensive. Even the U.K. film and television industry has been the beneficiary of EU funding, affecting the future production of shows such as HBO’s Game of Thrones, which is filmed mostly in Northern Ireland.

While these types of economic and trade risks are very real in the short term, we expect that they will be largely resolved in the longer term – somehow. The consensus seems to be that Europe will reorganize in a way that will keep Britain in the single market, but the details will likely emerge slowly and painfully.

From our view, the largest remaining concern is that other EU members will be encouraged to hold their own referendums, with potentially similar results. We have been concerned for years about a departure from the EU, though we have worried much more about a move by one of the countries in the eurozone (i.e., the 19-country subset of the EU using the euro). A departure from both the EU and euro would be, in our opinion, far messier and riskier than a U.K./non-euro departure. And if it were a prospective exit by one of the larger eurozone countries – Germany, France, Italy, or Spain – we would be very nervous and would consider significant changes to your portfolio. World leaders have voiced public concern over such dislocation risk having been precipitated by Brexit, boldly emphasizing the need to rethink the union immediately. French Prime Minister Manuel said of the U.K. exit, “It's an explosive shock. At stake is the break up pure and simple of the union. Now is the time to invent another Europe.” We hope and believe that a significant eurozone departure will be avoided, if for no other reason than the risk of the consequences is so large. Some of the potential country-specific consequences are outlined in Figure 3 below.

Figure 3

Figure 3

Impact on Your Portfolio

From an investment perspective, Brexit means that our long-term expected returns for U.K. and European stocks will decrease. At this point, it’s difficult to think through the implications for the U.K. itself, let alone the EU. Even in the U.S., it might be that expected returns are reduced slightly; Europe is nearly 25% of global GDP, so a slowdown in the EU would affect most companies around the world to some small degree.

But while we aren’t yet able to quantify the reduction to our expected returns, we do not believe the decrease will be significant. As a result, we do not anticipate substantial changes to your portfolio holdings.

 Our economic-growth-rate assumptions, just one part of our expected returns for stocks, were already quite low in all developed markets (including the U.S., Europe, and Japan). And most of our long-term expected return for European stocks is derived from four factors not (directly) dependent on economic growth: dividend yields (and net share repurchases), an increase in corporate profit margins, an increase in valuation levels, and an increase in currency value. As a result, the expected return for your European stocks will decrease only moderately, despite the still-slower economic growth now expected.

In summary, we believe the long-term impact to your portfolio from the U.K. exit will be minimal. Any reduction in our European stock-market expectations will be small, and those changes will be muted by your portfolio’s non-European-stock-market emphasis (nearly 80% of your stocks) and bond exposure (with no expected change in its expected return). With a little luck, the current volatility might even present us with an opportunity to add a new, attractively priced security to your portfolio. Stay tuned.