Is Brexit Lehman 2.0?

| About: SPDR S&P (SPY)
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Summary

Global markets have fallen sharply in response to the United Kingdom's historic decision to leave the EU.

Brexit has the potential to be a Lehman Brothers-style event depending on how governments and central bankers react.

Investors should tread very carefully in the days ahead as high levels of fear, uncertainty, and doubt begin to take hold.

Introduction

The British people have decided to leave the European Union. In a historic vote, 52 percent voted to leave the EU while 48 percent voted to stay. This vote has upended global markets as investors begin to digest what happens next.

So far the news has been brutal. The British pound is down 10% and has hit a 31-year low. Oil has fallen below $48/bbl. Gold is up above $1300/oz. The Dow Jones Industrial Average was down over 500 points in early trading. In short, the markets are reacting in a similar way to what happened in September 2008 when Lehman Brothers collapsed and sent shockwaves across the global economy.

Looking back at the events surrounding Lehman Brothers collapse in 2008 and its parallels to Brexit can help inform skittish investors. Savvy investors are trying to figure out what to do next. Looking to the past to help inform the present is a valuable exercise during this particular period of market turmoil.

Lehman Brothers 2.0

At first glance, the comparison between Brexit and Lehman Brothers may seem like an exaggeration. However, looking at the parallels between the two events demonstrates a striking degree of similarity between both and the market reaction to them.

In the case of Lehman Brothers, trouble began Wednesday September 10, 2008. On that day, Lehman revealed its first quarterly loss since going public. On September 12, Lehman began to aggressively search for a rival to either purchase assets or its entire business. Over that weekend, top bankers and Treasury officials met to discuss potential options for Lehman Brothers and broader remedies for the problems facing the financial sector. However, the government appeared unwilling to help out Lehman Brothers because it had already provided an earlier $229 billion bailout for Bear Stearns, Fannie Mae and Freddie Mac. Consequently, on September 15 Lehman Brothers filed for bankruptcy, which then set off the financial market meltdown.

Taking a step back, the trouble with Lehman Brothers did not occur in a vacuum and had been preceded by months of market volatility and problems in the financial sector. The subprime mortgage crisis had already seriously harmed broad swathes of the financial industry and this began to spread across to other parts of the economy. When Lehman Brothers finally fell, it was the straw that broke the camel's back.

Looking at Brexit, there are eerie similarities in both the short- and longer-term timeline. This past month has been a roller coaster for equities.

With fear of a Brexit rising, equity markets around the world began to take a dive at the beginning of last week. As polling data demonstrated an increasing likelihood of a Brexit, this served to increase volatility on the market, and depress global equity markets.

But this week, polls began to show Brexit might not happen. This led to a rally in global equity markets. However, Brexit became a reality today and the market is pulling back sharply, just as it did after the collapse of Lehman.

Brexit may be the straw that breaks the global economy's back this time around. The global economy today is even more connected than it was in 2008. This is why Brexit has such profound consequences for both the US and global markets.

Looking at events before Brexit, there have been signals of economic trouble just as there were signals of economic trouble before the collapse of Lehman Brothers. Last August, the Chinese economy began to dip and nearly brought the global market down with it. This past February, the decline in global crude prices led to a sharp market decline with the Dow Jones industrial average falling all the way down to 15,660. At the same time, a flight of capital from emerging markets to developed markets indicated increasing investor concerns about the stability of the global economy.

Mark Twain famously said, "History doesn't repeat itself but it often rhymes." Although there are differences between the Lehman Brothers event and Brexit, there exists broader similarities of markets unnerved because of fundamental problems. Lehman Brothers finally pushed the market over the edge after months of economic uncertainty. Similarly, Brexit could be the event that finally pushes the market over the edge after the latest round of economic uncertainty.

Investment Strategy

Given the reality of Brexit, what should investors be doing? There are three strategies investors can employ during market crises, each of which has its owns risks and rewards.

The first is simply to do nothing. Selling out of fear can be a recipe for disaster, especially when the downside is unknown. Sure the market is reacting very negatively right now, but will it remain this way by the end of the day? After Lehman collapsed, the markets immediately tanked. But looking at the actual data from around that time shows things did not collapse all of a sudden:

Source: Yahoo! Finance

As can be seen from the data, although the Dow fell 500 points after news of Lehman's collapse, it rebounded a bit during the next trading day and closed above its open price on September 16. It wasn't until the end of September when the contagion continued to spread throughout the market that things really fell apart.

Today the market is paring back gains from this week and then some. Although it is likely the market will continue to see steep declines in the days ahead, the extent of damage may be mitigated by central bankers stepping in to reassure the markets. In fact, the Bank of England has earmarked about $344 billion for potential stability measures.

The alternative to this is to actively trade the market. A lot of money can potentially be made shorting the market, or shorting particularly overvalued securities. Or for those preferring to go long, gold may continue to rally in the days ahead. Alternatively, buying 10-year Treasury notes could be a safer place to park capital. For long term investors who don't mind holding positions for years, now may be a good time to enter into a long position in securities that are already undervalued.

3-month gold chart, Source: Nasdaq

The third strategy involves a mixture of both. Selling out of winning positions could be smart and buying back in at a lower price may be advantageous. However, investors must pay close attention to short- and long-term capital gains to optimize this strategy. Timing the market is notoriously difficult, especially since there is no guarantee which way the market will go.

The bottom line for investors is to recognize that the market is facing a black swan event and things could get a lot worse. Brexit has the potential to send the already tenuous global economy into a downward spiral. However, a lot depends on how central banks and governments react.

Conclusion

Ultimately, retail investors should not make any drastic moves in the market today. After all, there is still a chance the UK government may not leave the EU after all, since the referendum is merely a recommendation and not mandatory. It is conceivable that the next Prime Minister decides to keep the UK in the EU for the good of the nation, even if it overrides the popular vote. This could send the market rocketing back the other way, though the likelihood of defying public opinion may be too difficult to overcome.

Any strategy individual investors decide to employ needs to be disciplined. Selling out of fear as a strategy can lead to epic losses. Buying or shorting out of greed can also lead to epic losses. Investors should remain disciplined and not get drawn into the vicious cycle of fear, uncertainty, and doubt. Perhaps it is best to follow the very British advice of keeping calm and carrying on.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.