Brexit is landing a body blow to the Dow and the S&P today. And investors should feel pretty good about it.
U.S. Stocks dropped on Friday as the investors digested what the effects of the U.K. Leaving the European Union would mean for the U.S. Economy. Of the 30 stocks in the Dow Jones industrial average, only one, Walmart (WMT) was up. Of the other 29 that were down, the worst performer was Goldman Sachs (GS), which was down nearly 5%, or $7.50 a share to $140. The next worst performer was Caterpillar, which was down nearly 4.5%.
In all, the Dow was down over 500 points by mid-day. And the S&P 500 was off 61 points, or just under 3%.
As measured in real economic terms, a Brexit news shouldn’t actually be all that bad for the U.S. The U.K. Accounts for only a small portion of U.S. Exports, less than 3% of the combined revenue of all of the companies in the S&P 500. Europe in general makes up a bigger portion, and the economic consequences of Brexit for the rest of the EU will likely be limited, at least in the immediate future.
But over the past few years markets and investors have tended to overreact in the short term to any alarming news, especially to big events like a Brexit. The reason has to do with financial markets. While a Brexit likely can’t cause all that much economic damage to the U.S., a drop in financial markets can, as we learned during the financial crisis. So in recent times, when there has been a whiff of trouble (and today is more than just a whiff) investors have hit the exits, concerned that a big sell off could turn a small economic problem into a big market problem, which could then generate a much bigger economic one. The feedback loop has been toxic.
And right now we should be more vulnerable to a market sell-off than usual. Stocks in the S&P 500 are at an average price-to-earnings ratio of 23 (based on Robert Shiller’s formula for normalizing earnings) compared to a historical average of 15. That, along with the shock from Brexit, would be a combo you’d think would sent stocks tumbling.
And yet while the market is falling, we’re not seeing the death spiral that all these trends might make you expect. And it comes after a number of months of pretty good stock market returns. Indeed, today’s drop has sent the market only back to where it was in mid-May—just 30 days ago. What’s more, the VIX—the stock market “fear gauge,” which measures how much people are paying for protection against future market drops—is at 22. That’s below the 28 it hit this February, and well below the high of nearly 60 it hit during the financial crisis.
Indeed, there may be some fundamental reasons for the overall lack of panic. Economic turmoil abroad will give cover for the Fed and Janet Yellen to raise rates. Companies in the U.S. That compete with the U.K. To sell goods in Europe may have an easier time. And the U.S., New York City in particular, may be able to lure back some financial jobs from firms that are pulling people out of London, though it’s more likely that those jobs would go to some other European capital.
For much of this year, there has been a question of how strong the economy and whether there has been a loss of confidence from investors and consumers. But what today shows, so far, is that investors are much more confident about U.S. Stocks, the financial system, and the economy in general than we expected. It may have helped that just last night the Fed gave passing grades to every big bank in the nation on its annual stress test. But either way the big story from the market today is not how much weaker it is from Brexit, but how relatively strong it is despite it.
