Whenever share prices fall significantly investors should ask: is this because future dividends will be lower, or is it because risk aversion has increased?
The distinction matters enormously. If dividends will be lower in future share prices will stay low because they have become genuinely worse investments: the cashflows upon which they are claims will be smaller. If, however, risk aversion has risen there might be a buying opportunity for the braver investor because (in theory anyway) higher risk should mean higher returns.
So, which of these explanations applies to the post-Brexit drop in UK shares?
We have two reasons to hope the fall is temporary.
One is simply that prices have fallen so far. As I write, the FTSE 250 is down by ten per cent since Thursday: this is a better gauge of domestically-oriented share prices than the FTSE 100, which is dominated by multinationals some of which have little exposure to the UK economy. This is greater than even the most pessimistic economists' assessment of the long-term impact of Brexit upon GDP - he Centre for Economic Performance’s estimate of a nine per cent hit. (Most economists’ estimate the impact will be only around half this: the NIESR, for example, puts this cost at 2.7-3.7 per cent.)
This raises the possibility that shares might have overshot on the downside. If dividends move in line with GDP, prices might well have fallen by more than future dividends. We know that markets have often over-reacted to good and bad news in the past. Maybe they're doing so now.
A second reason for hope is that uncertainty might now be as high as it is going to be, and as it declines shares should rise.
We can quantify this, at least roughly. There has been a strong correlation for years between Stanford University’s index of UK policy uncertainty and the dividend yield on the All-share index: it’s been 0.51 since the uncertainty index began in 1997. This relationship implies that a one standard deviation fall in policy uncertainty would reduce the dividend yield by 0.3 percentage points. That’s equivalent to an eight per cent rise in share prices. The benefits should be greater for the 250 and smaller stocks than for the FTSE 100.
Thirdly, it's possible that central banks (around the world and not just in the UK) will respond to the recent global falls in shares by expanding quantitative easing. This could put a floor under prices.
So much for the optimistic case. Sadly, however, there are many reasons to doubt it.
One lies in distribution risk. The idea that shares have fallen more than future dividends rests on the assumption that these will move in line with GDP. This might be too optimistic. Pro-Leave Labour MP John Mann has called the referendum result “a mandate for workers’ rights”. This might be hyperbole, but it hints at a danger for shares - that the populist sentiments revealed by the Leave vote include support for other anti-business policies. Yougov polls have shown that there’s big support for nationalization, high minimum wages and price controls. Such populist policies might, in the long-run, cause a fall in the share of profits and dividends in national income. From this point of view, the market’s fall doesn’t look so excessive.
A further problem is that uncertainty might not fade away soon. Ralf Preusser at Bank of America Merrill Lynch warns that it will stay high “for a long time.” He fears that negotiations about the terms of the UK’s departure will be long and hard because each EU member state has different interests to protect and the EU won’t want to offer generous terms for fear of encouraging others to follow the UK out.
“This huge degree of political uncertainty is going to be massively disruptive for the economy” says ING’s James Knightley. Whilst trading rules remain unclear, some firms will be reluctant to invest and hire. Stanford University’s Nick Bloom has shown that uncertainty can have a chilling effect upon economic activity, and his view has been vindicated by a poll from the Institute of Directors showing that many firms plan to cut investment and freeze hiring as a result of Thursday's vote.
Whether this chill will cause an outright recession is a matter of debate. Mr Preusser believes it will, but other economists are slightly more optimistic*, believing that sterling’s fall will help cushion the economy and that the Bank of England will loosen policy: Investec’s Philip Shaw says a cut in Bank rate, perhaps to zero, is “likely”. Whilst this might help support share prices it of course means that savers will face even worse returns on cash.
Even if Brexit does prove relative benign in the long-run, this near-term uncertainty - which might last for years - could weigh upon equities.
Yet another problem is that policy uncertainty might spread if the UK’s vote emboldens populist movements across Europe. The leave vote “will set off a domino effect of political risk” warns Dominic Rossi at Fidelity. Berenberg’s Holger Schmieding adds that the risk that other countries will follow the UK out of the EU “loom much larger than before".
This is an especially nasty risk for euro zone banks, warn economists at Fathom Consulting. Losses on their sterling positions might well be followed by losses on riskier bonds, caused by the widening of credit spreads. It’s for this reason that two of the stocks worst hit by the Leave vote have been Commerzbank and Deutsche.
All this suggests that stock markets’ fall might not represent a significant buying opportunity. Instead, they might be reasonable responses to the dangers of prolonged uncertainty and lower than previously expected future dividends.
This doesn’t mean the UK market is doomed to stagnate, however. We still live in a global economy, and if this strengthens UK equities should share in the good news. This, rather than domestic developments, is perhaps the best hope investors have.
* We shouldn't get hung up on this: the difference between a small increase and small fall in a number that is badly measured anyway is not terribly important.