To evaluate the reaction of the US stock market to Brexit remember that stock prices reflect the discounted present value of expected future cash flows at the proper risk adjusted discount rate. When the market drops sharply, it must be because the marginal investor has either reduced expectations for future cash flow or increased the discount rate. While stories can be told about how the British action will depress American business, they seem farfetched. In fact, it is even possible that turmoil in Europe could help American companies. It is hard, therefore, for me to see how Brexit reduces expected cash flow for US companies. The discount rate is a more likely culprit. The fact that credit spreads widened indicates that investors were demanding greater expected return in light of what they thought was the enhanced risk of holding US equities. That would explain the drop. However, it is also hard for me to see how Brexit makes US equities riskier on a long-term basis and it is the long-term risk that ultimately determines the value of equity securities. The bottom line is that Friday I did what I consistently recommend one should not do – try to time the market. Because I see the drop as short-term, I piled into US equities with the hope of profiting in the next few weeks. Bad decision? Quite possibly. Stay tuned.
