The term “Black Swan” was popularized by Nassim Nicholas Taleb who was a Wall Street trader and a finance professor. The definition of the term is an event that is well beyond what one would normally expect given a certain situation and also would be extremely difficult to predict. Needless to say, when applied to the equity markets, the Black Swan event is usually followed by precipitous volatility which can leave an investor’s capital dangerously exposed.
While Black Swan events are hard to predict, there is one possible event that seems to be looming on the horizon for all to see, and that is the growing threat of the Iranian nuclear facilities. While the rest of the world concentrates on the European debt crisis, possible bond defaults, and a sagging U.S. economy, a real catastrophic set of events is falling into place that might make the Greek financial crisis look like a kindergarten sideshow.
For this article we shall start the series of events with the recent uprisings across the Middle East as the populace overthrew dictators and oppressive regimes. Oftentimes these dictators don’t relinquish power so easily, so inevitably you get political and civil upheavals that tear up the infrastructure and fabric of the country. No better case exists than the prolonged insurrection in Libya that took a large percentage of that country’s oil off the market.
To this, add similar revolts in Egypt and Syria and you get a very unstable situation in the making. If that was not enough, consider the recent saber rattling by Turkey against Israel, and you will get the whole region on the razor’s edge. But the real concern actually lies far to the east from Israel in the form of the Iranian nuclear facilities, for there lays the source of our possible Black Swan event.
Now, whether the Iranian nuclear facilities will be used primarily for electrical power or weapons manufacturing is really the point of the debate. The answer to that question is probably both. What is not debatable though is the highly aggressive and threatening tones that come from within the Iranian government dealing with the right of the nation of Israel to exist. As international diplomacy grinds on without fruition, the chances of a major military clash become more likely as Israel will only be restrained for so long. When one's homeland is threatened in such a manner, that nation will go to whatever length it deems necessary to protect itself.
This situation is nothing new to the Israelis. They have dealt with such threats before when in 1981 they destroyed Iraq’s nuclear reactor at Osirak, and then again in 2007, wiping out a North Korean-built reactor in Syria. This time will be different though as Iranian facilities are well protected and spread out over a large area. A handful of planes will not be enough to carry out Israel’s objectives. In this case they will need a large armada of planes to get the job done.
The strike itself, unless nuclear in nature, will not be the Black Swan event for the global equity markets. The deciding factor will be how the Iranians react to such an attack. Iran will see an opportunity to unify its divided people, but what action will they take? It is highly doubtful that they would be able to pull off a similar strike as they will probably not want to tangle with a local American military presence as well as the Israeli Defense Forces (IDF) who at that time will be expecting such retaliation. Iran’s best weapon might be to play the oil card and begin a chokehold on the Strait of Hormuz.
This Strait measures 34 miles across but the key passages through the Strait consist of 2-mile wide channel plus a small buffer zone. The issue is that 40% of the entire world’s traded oil flows through that point. Even a country with limited military capacity, like Iran, could make transit through those narrows a hellish nightmare. Closing the Strait, even for a limited time, would be enough to drive prices for oil to outlandish levels. Keep it closed for an extended period of time with ongoing military clashes in the region, and the end results could be catastrophic.
This would be the Black Swan event that would sink the equity markets for a time. In the end, it is doubtful that Iran could keep the Strait closed for long as outside political/military pressure would eventually open the passageway. Besides, the closing of the Strait would also deal Iran itself an economic blow that they can hardly afford now.
If the Iranians were to shut the Strait down, the impact on the price of oil would be immediate. The intensity/length of the conflict would tend to make the prices even that much more volatile. As the world needs oil to run, any interruption in the flow will be seen as very negative by investors and traders. In turn, these traders and investors, who usually sell first and ask questions later, may very well trigger a selloff in the worldwide equity markets. Get the price of oil over $200 a barrel and things can get pretty dicey rather quickly.
The question is, how can one protect their investments if such an event were to occur? The answer to that question will obviously vary from investor to investor and is very complex in nature. That being the case, here are some basic concepts and ideas that could be considered to try to hedge against such an event.
One obvious way to protect one’s investment capital is by buying puts, but in this circumstance one would have to be careful. Due to the nature of a Black Swan event, no one knows when or even if the event will occur. Buying puts on individual holdings in one’s account can be expensive. If the event fails to materialize, the buyer of the puts can rack up some substantial losses as the puts expire worthless. Or, if the event does happen to materialize but your puts expire before the event occurs, you will not only suffer the effects of the Black Swan event, but you could also book losses on the expired puts.
That being the case, puts are some of the best protection that one can have. In this case, it might prove beneficial to buy puts against ETFs which mirror certain markets or indexes. For example, one could buy long term puts against such ETFs as the SPDR Dow Jones Industrial Average (DIA), which represents the DOW, or the SPDR S&P 500 (SPY). Any Black Swan event will surely have a negative impact against either of these ETFs, which will drive the price of the puts much higher.
The challenge is that one would need to determine the correct time frame to buy these puts so they don’t expire worthless. Also, one would need to determine what strike price would be best to buy the puts. If one were to purchase puts at too low a strike, they might fail to protect their assets as the Black Swan event never drove the price of the ETF below the strike price of the put. On the positive side, buying the ETF puts might be cheaper than buying individual puts for each holding in one’s account, but make no mistake, the cost in doing so will still be substantial.
If puts are not your game, one could always consider inverse funds. These investment vehicles are fund/ETFs that profit from a decline in the value of an underlying benchmark which they are set up against. They are constructed by using various derivatives which make it similar to holding short positions. So buying these funds will basically make one a winner if the corresponding benchmarks were to sell off based upon a Black Swan event.
There even exist leveraged inverse ETFs (also known as “ultra short” funds) which seek to achieve a return that is a multiple of the inverse performance of the underlying index. In the long run, these leveraged funds do not deliver on their promise, but they can be very useful for short term protection. Some great examples of these inverse funds are the ProShares Short S&P500 (SH) or the leveraged ProShares UltraPro Short S&P500 (SPXU). Unlike the puts above, these ETFs will not expire and will provide protection for as long as one holds them in their account. The downside is that if the Black Swan event fails to materialize and the markets were to trend higher, one would steadily lose the capital they invested in the original purchase price.
Probably one of the best ways to capitalize on this potential Black Swan event is to focus on the commodity that is at the heart of it all. The Strait would be closed to squeeze the flow of oil, and that is what one should focus on. One ETF that attempts to follow the price of oil would be the United States Oil Fund LP (USO). Although it’s not the most efficient tracker of oil prices, the fund is actively traded and is very liquid. For a leveraged fund, one could check out the ProShares Ultra DJ-AIG Crude Oil ETF (UCO). This fund seeks to provide daily investment results that correspond to twice the daily performance of the Dow Jones UBS Crude Oil Sub-IndexSM. Either one of these ETFs would have a major increase in share price if the price of oil were to spike.
At first glance one would think that the energy companies like an Enerplus Corporation (ERF), Penn West (PWE), or countless other entities would be immediate beneficiaries of the spike in oil prices. Since many of these companies are incorporated into major trading indexes, they could very well feel the negative effects of the potential global selloff. Also, the sheer panic that the Black Swan event could spiral out of control, even more so than just closing the Strait, would be enough to bring share prices down in the short term as investors run for cover.
In the end though, this might prove to be a buying opportunity because at some point the Strait would have to be reopened. Iran cannot afford to have this passageway close for any great period of time as the economic damage would be tremendous on their economy. A temporary closure would be enough to keep tensions in the region elevated and oil prices higher for an extended. After the event had passed and flow of oil resumes, most energy companies would benefit in the long run by the inflated oil prices that would remain in the wake of the event. So, to sum it up, the energy companies would probably not offer an investor much protection at first, but once the event had passed they should benefit in the end.
In conclusion, the potential Black Swan event surrounding the Iranian nuclear facilities is really a big unknown. Many people think it is debatable if the Israelis would attempt to mount such a large military operation over such a vast distance against these elusive targets. On the other hand, the Israelis, armed with their “Never Again” philosophy, will not sit quietly and hope for the best. Being one of the most advanced military powers in the region, it is hard to imagine that they will not act to protect their nation from the perceived threat as they have done in the past.
Iran’s response could be as a muted as simple national protests all the way to plunging the entire region into a costly military conflict. For the investor, knowing is half the battle and this issue is not hard to follow. The final question for each investor is what, if any, protection they might enact if the Black Swan event were to come to fruition.