Britain’s vote to leave EU is shaping up as a black swan event

By Christopher Langner

Britain’s vote to leave the European Union is shaping up as a black swan event. Despite polls showing split intentions, investors hadn’t fully priced in the Brexit vote. History suggests the pain is far from over, even if markets end higher this week.

The 4.9% drop in the MSCI World Index on Friday was more than six standard deviations higher than the average daily return for the broad stock benchmark. Those dislocations are very rare. Some of them, however, have been followed by misleading bounces shortly after the initial sell-off. And it’s precisely those examples that turned out to be the nastiest in the medium term. The most remarkable, and perhaps clearest, example was when Lehman Brothers filed for bankruptcy on September 15, 2008.

That day, the S&P 500 tumbled 4.7% but went on to end the week 0.3% higher. The gauge then proceeded to lose 29.3% over the following three months. Key to the index’s fall over a longer time was the seizure of interbank liquidity, which didn’t play out entirely in the first week. More recently, on Thursday August 4, 2011, the MSCI World dropped 4.3%, a more than six-sigma shift, ahead of Standard & Poor’s decision to downgrade the US from AAA. By Monday’s close, the gauge had slid 6.3% but by Friday, had gained 4.2%. The benchmark found its bottom for that year on Oct. 4 at 1,074.50. By its peak on May 21, 2015, investors were sitting on a 68.5% return.

Difficult To Pick There are other examples of dead cat bounces further back, too. A mini-crash ensued on October 27, 1997 after investors realized nations in Asia were going to have to massively devalue their currencies.

The MSCI World fell 4.4% that day only to rally the next two days before slipping to a low that year of 889.80 on November 12. In the 12 months that followed, the index returned 17%. It’s hard to apply history lessons to an event as unique as Brexit. Yet many investors are wondering whether Friday’s sell-off was overdone: witness today’s 2% rebound in Japan’s Nikkei 225 Stock Average. Baron Rothschild is credited with saying that the “time to buy is when there’s blood in the streets,” and it’s true that market dislocations such as these often present opportunities for investors with a longer-term horizon. To think that less than a week after such a seismic event the worst has passed would be naive.