Market History

Using the past to rationally predict the future.

Why we’re selling U.S. stocks before the French election

The French election on April 23 just got decidedly more bearish for European and U.S. stocks.

There are 4 main candidates in the first round election on April 23. The 2 candidates with the most votes will go into the 2nd (and final) round of voting, which will decide the next French President on May 7.

  1. The far left and far right candidates both want to leave the EU and the Euro. The far left claims that free trade is killing the French economy while the far right claims that unrestricted immigration is killing France.
  2. The two guys on the center both want to maintain the status quo and stay in the Euro.

Previously, centrist candidate Macron and far right Le Pen were clearly in the lead for the first round of voting. Le Pen was expected to win the first round by a small margin, while Macron was expected to come in 2nd. Then Macron was expected to beat Le Pen by a huge margin in the 2nd round.

But recent polls show that the far left candidate Melenchon is neck and neck with centrist Macron! So if Macron loses on April 23, the final election on May 7 will be between 2 candidates that BOTH want to leave the EU/euro: Melenchon and Le Pen. No matter who wins, France will move towards a referendum to leave the EU like Britain did last year.

The euro will likely crash if centrist Macron doesn’t come in at least 2nd place on April 23. The euro will start to unravel because France is the 2nd biggest economy in the EU.

But more importantly, how will this affect U.S. stocks?

The worst case scenario: what the pessimists are saying

The pessimists believe that a Macron defeat will cause the S&P 500 to crash 15%, 20%, or 25%. They also believe that the Eurozone’s recent uptick in economic growth will stop and the EU economy will deteriorate rapidly. They say that Brexit was just a preview of what’s to come.

The differences between a “Frexit” and Brexit

The S&P 500 fell 6% on Brexit (June 24 2016). Comparing a Macron defeat to Brexit will let us guesstimate how much the S&P 500 will fall this time.

A Macron defeat will be more severe than Brexit. The fundamental difference is that France uses the euro while the UK did not.

Since the current situation is more severe than Brexit, expect the S&P to fall more than it did last time. I.e. the S&P will probably fall more than 6%.

In addition, if Frexit happens then 2 countries (France AND Britain) would have left the EU. When the UK voted to leave the EU, they were to only ones to do so at the time. In other words, the situation is getting worse and worse for the EU.

Why we don’t think the worst case scenario will happen

A 15%, 20%, or 25% decline seems unlikely. In the worst of times – in the heat of the 2010 Euro crisis – the S&P only fell 17%. Hence, the magnitude of this S&P correction S&P will be 17% at most.

Since the S&P is already down approximately 3% from its highs, the S&P can fall at most 14% on the French election results.

However, the current situation is definitely less severe than it was in 2010, when the Euro was ALREADY on the brink of collapse. Hence, the S&P will probably fall less than 14%.

Using these 2 pieces of logic, we believe that the S&P will probably fall 7-14% on Macron’s defeat.

Why we’re selling stocks on April 21, right before the French election

There are 2 main possibilities that will arise from the April 23 election:

  1. Macron finishes in the top 2 and goes on to Round 2 with Le Pen. In this case, all bearish concerns are absolved. Macron is expected to win by a BIG margin in the 2nd round. People tend to vote for the center in Round 2.
  2. The far right and far left candidates finish in the top 2, defeating the centrist candidates.

In the first scenario, the S&P might rise 1-2%. So if we’re sitting in cash, we’ll miss out on a 1-2% gain. But if the 2nd scenario happens, the S&P will crash 7%+ in just a few days. From a risk:reward perspective, it’s better to forego a 1-2% gain than to risk a 7% loss.

The odds of these scenarios are 50-50 right now.

  1. If the first scenario happens, we will buy back our stocks on April 24 because this risk has disappeared.
  2. If the second scenario happens, we will buy back our stocks once the S&P falls 5%. Perhaps the S&P will fall 10%, but who knows. We cannot predict that.

*We invest in UPRO, the 3x ETF for the S&P 500. Sidestepping a 5% decline in the S&P 500 equals to sidestepping a 15% loss in UPRO.

It’s still a bull market

We need to protect ourselves against the worst case scenario. We do not think a bear market in U.S. stocks will ensue if France leaves the EU.

The U.S. stock market’s long term direction is determined by the U.S. economy. France leaving the EU will hurt European economies, but there will be little economic contagion to the U.S.

  1. The U.S. is a relatively closed off economy.
  2. European economies will not go to hell straight away. European economic data will witness a temporary dip at first. After the far left or far right candidate wins, France needs to have a referendum on whether or not it will leave the EU. The lead up to that referendum will take months. If France votes to leave the EU (and that’s a big “if”), France will begin a multi-year process to abandon the Euro and leave the EU.

This is not a crisis scenario for European economies or the U.S. economy. Hence, it is not a crisis scenario for the U.S. stock market.

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