Black Swans are not so Black (or rare)

Mon 26 Feb 2018

A “Black Swan” is a very popular notion in modern stock market commentary, yet the phrase originates from a time before the public listing of stocks. In 16th century London, people used an old Latin quote : “a rare bird in the lands and very much like a black swan“, based on the presumption that all swans must be white because all historical records reported that they had white feathers. Therefore, a Black Swan would be very rare. The concept was re-popularised in 2001 by Nassim Taleb in his breakout book, “Fooled By Randomness”, and is symbolic of an event that comes as a surprise, is impactful and is often rationalised after the fact. A “Black Swan” is the unpredicted event that ends a market cycle, plunging investors in a new bear market. Should investors be worried about them?

We do not believe that Black Swans are as rare as popularised lore would have it. In fact, they may be observed daily. From the dangers of populism and geopolitical concerns to the rising costs of money, from the impact of new technologies to European politics and the Euro, there are plenty of events out there that can be potentially classified as Black Swans. To use the analogy, no swan is a Black Swan, until actually called so. It can spend its life in white or grey, until the markets decide, in retrospect, that it has had a significant impact. While in 2008 the demise of Lehman was considered unpredictable, it is worth noting that articles written as early as 2005 said that the US real estate market would cause a market crash. The risk was rationalised, with many brokers arguing that the Subprime real estate market was not very important. Credit had been freezing a year before Lehman crashed. Bear Stearns had already failed. Yet somehow, Lehman’s demise was “unforeseen”. This is happens when we see the 15th of September 2008 in isolation from the long chain of events that preceded it.

What makes a “Black Swan” is really our own investor “confirmation bias”, the cognitive process by which we filter information according to a set of predetermined beliefs. If we collectively believe for example that the market is overpriced, then we may tend to pay more attention to events that would catalyse a fall, such as the recent failure of certain volatility products. If we believe the market is cheap, we could ignore geopolitical events, like Brexit, as traders prefer to buy the market dips. So what we should be asking is not whether there’s a chance for a Black Swan, but whether conditions are ripe for markets to acknowledge one. While long-term investors would do well to ignore trading patterns, it is conceivable that sharp market moves, most of which are explained through trading, can alter the long-term investor mindset. To put it simply, if the market is crashing and the Dow Jones is losing 1500 points in a single day, it is difficult for even long term investors not to be alarmed, even in the midst of the best earnings season in 7 years. But what really changed during the recent market correction?

At the beginning of February, we acknowledged that market fundamentals were not the same as in 2017. Some of the elements that were supporting the rally, such as momentum and constant investor attitude of buying the dips have been interrupted, while the macroeconomic backdrop, still very robust, has become slightly more challenging.

More important, the “Fed Put”, the US central bank’s implicit pledge that it will stand by risk assets is now under question, as the recent selloff coincided with the first day of a new Fed Chair. Central bank communications had been very important for market sentiment throughout the recovery and vice versa. For all the theory about the true mandate of central banks (i.e. inflation, employment and growth) a recent study by two economists, Anna Cieslak and Annettee Vissing-Jorgensen found that stock returns were more powerful in predicting the Fed’s interest rate target than 38 economic data points, including consumer spending, job growth and, yes, inflation. Federal Reserve communications and markets moves have gone hand in hand for nearly three decades. While critics argue that the Fed’s job is not to influence the market, but to promote stability, which means the Fed should talk only after a very significant correction, the truth is that traders, whether human or robotic, have been conditioned to look for Fed signs of reassurance, and in their absence could hesitate to provide support for falling markets.

In an environment where central bank policy is becoming gradually less accommodative, both to markets and main street borrowers, and where central banks choose to focus on their traditional role of controlling inflation, we could see more volatility, which translates as less drive by traders to buy market dips. In turn this could cause some pause for longer term investors and alarm CEOs, especially those who were in the cusp of making big spending decisions. In that environment, various risk events that would have otherwise been ignored are now becoming potential “Black Swans”.

Is that it for the cycle then? We don’t believe so, at least not yet. Fundamentals are still very strong, with the global economy expanding synchronously, autonomously (ie. without significant need for stimulus) and with corporations, and to some extent consumers, reaping the benefits. Our stance, during our last investment committee in early January, was to decrease our exposure in equities, bringing it to “Neutral”. When markets fell in February we chose not to reinstate our overweight equity position, pending greater clarity on the Fed’s attitude to stock market stability. However, until such clarity appears we remain vigilant and aware of an environment more volatile than 2017, but not yet near the cycle’s end. Barring a Black Swan that is…