Friday's Brexit roiled risk markets around the world, but it wasn't nearly as disastrous as the Lehman Brothers of September, 2008. Despite record price movements in the British pound currency, US markets are poised to weather the fallout from the United Kingdom’s secession from the European Union materially better than other markets. Nevertheless, significant headwinds remain, based on historical analogues.
Friday, the S&P 500 closed down 3.6%. The Dow Industrials closed down 3.4%, or 610 points. Since the seven year bull market began in March, 2009, this has happened only 8 times. It’s useful to go back and see what happened, and to discover why Lehman was a different situation altogether.
Mark Twain: “History doesn’t repeat, but it does rhyme.”
When Lehman Brothers filed for bankruptcy protection the morning of September 15, 2008, the S&P 500 was already in a bear market—down just over 20%. By the end of that day, another 4% was shaved off. Contrastingly, last Thursday, the S&P 500 was only about 1% off its all-time high. In addition, bank capital is much higher, and leverage is much lower than it was in 2008. Banking is getting boring again—the way it's supposed to be.
Context is critical when interpreting market moves. Bull markets trade differently than bear markets. And, despite the current market turmoil, we’re still in a secular (very long term) bull market. It might devolve into a bear, but this is where we are now.
Past is prologue
On August 4, 2011, during the debt ceiling crisis—one day before Standard & Poor’s downgraded US government debt—the S&P 500 sold off nearly 5%. It would take 61 trading days (nearly 3 calendar months) to find the bottom. And it would take over a year to climb to a new all-time high.
Similarly, the Flash Crash roiled global markets on May 6, 2010. Intraday, losses in the S&P 500 reached 8.7%. Thanks to a substantial end-of-day rally, closing losses were pared to 3.2%, which is slightly less than Friday’s Brexit loss. Nevertheless, it’s instructive to study the fallout because the effect on sentiment was the same. That time, it took 56 days to reach the bottom (again, nearly 3 calendar months), and the prior all-time high was eclipsed 192 days later.
The bottom line is: Be prepared for a minimum of several months before the ultimate low is reached.
Traders, not investors, run these markets because they’re the ones who provide liquidity. Right now they’re skittish. There will be some scary days ahead. The S&P 500 will likely test the 1850 level, which is nearly 10% lower. At that point, long-term investors can feel free to bottom-fish.
After “blood runs in the streets,” sentiment will improve as news becomes more positive. There might be a Brexit reversal. EU leaders might start playing ball. Fundamentals don’t matter. Liquidity does. And liquidity will once again return to the markets—only to be pulled again on the first negative development.
It will be two steps forward, one step back, until there’s sufficient confidence to overcome event risk. When dire news is announced and risk markets close up on the day—that’s when the worst is over. Until then, trade cautiously.