With the possibility of Brexit rising, it is a good time to review where the UK market might head next, so we aren’t too scared and can prepare to pick up bargains.

I invariably start my analysis of the footsie with a pencil and a ruler. Here’s why (aside from the 30 years of experience informing me how useful is this simple tool).

Investors (including the professionals who might be managing £billions) are both emotional creatures and creatures of habit. On a graph of any stock market it is possible to observe where those investors got into the habit of either buying or selling in the past.

For example, if you look at the chart of the FTSE 100 index at the end, the red line shows that since 2010 investors got into the habit of buying when the stock market fell to around 5,000 – what we call a support line for the market.

When markets are very volatile, particularly when the trend is down, investor decisions are increasingly driven by fear. In such a situation a habit which stood us in good stead previously (in this case buying at around 5,000) acts like a comfort blanket, putting a dampener on the market falling much further.

If you have read to this point you might think that the actions of investors (or this analysis) are infantile. Perhaps you are right. But it is precisely because investors act like this (you and I included) that governments, central banks, regulators, the huge investment banks and academia spend so much time and effort on what is called Behavioural Finance:

Behavioral finance is a field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions

So you can have a pretty good stab at how far the market might fall without beginning to consider why the market might fall to that level. It is important to recognise that we aren’t trying to forecast that the market WILL hit 5,000, rather trying to visualise to where the market might fall. This is very useful if you want to succeed at investing because you can rehearse how you will behave if the market hits that level e.g. not panic into selling, and start utilising a “shopping list” of what to buy.

It is useful to also have an idea of why the market might fall to this level, to understand that all your rehearsal and planning is not for a highly unlikely outcome.

This is not just about the UK and Brexit. Clouds are gathering globally. Don’t overlook the rapidly approaching Spanish vote – if we get both Brexit and a big vote for Podemos (and friends) in the Spanish election the skids will truly be put under markets. Then factor in the Italian government falling in the Autumn (they have a referendum too) and a win for Trump in November. Not forgetting that the latest economic numbers out of the US have sharply increased the likelihood of a US recession, and that the imminent bursting of the giant Chinese debt bubble is perpetually being forecast – one day they might be right.

Perhaps you now feel 5,000 is too optimistic? In which case you might also want to rehearse how you will respond with the UK stock market at 3,500 – because that is the “comfort blanket” below 5,000. Remember, don’t try and forecast whether that might happen, but rather what action you will take (how you will behave) if it happens.

 

[originally published 17 June 2016]

 

FTSE 100 at 5000