Hunting For The Next Black Swan

| About: SPDR S&P (SPY)

Summary

Investors are increasingly watchful of events that might signal a major change.

One such signal may be a black swan: an unexpected event that precipitates a large decline.

The grey swan is a more useful concept for identifying major changes.

The first known occurrence of the phrase "black swan" is attributed to the ancient Roman poet Juvenal. Rara avis in terris nigroque simillima cygno, or "a rare bird in the lands and very much like a black swan," was a metaphor for a thing that does not exist. When black swans were discovered in 1697 in Australia by Dutch explorers, the meaning changed to "something extremely rare." Nicholas Taleb brought the term up to date first in his 2001 book Fooled By Randomness and expanded it in the 2007 The Black Swan. Taleb's black swan has three salient characteristics: it is rare, has an extreme impact, and can be predicted only in retrospect.

As the bull market grows longer investors are increasingly watchful of events that might signal a major change. One such signal may be a black swan: an unexpected event that precipitates a large decline. (Although the black swan can be bullish as well as bearish, a large negative change seems most likely under current conditions.) The Lehman Brothers 2008 bankruptcy, the last black swan, is prominent in market lore and memories of it are still strong. A number of questions on the subject naturally arise:

How common is the black swan? Where should we look for it? How will we recognize it?

Source: alamy.com.

How common is it?

Like another animal, the yeti, black swans are far more discussed than seen. The one burned into our brains is the failure of Lehman Brothers in 2008. It was one of many corporate failures during the Great Recession and is remembered as the moment when everything fell apart. But there was no "Lehman moment" in the economic declines in 1987 or 2000. Since 2008 there have been many potential black swans, including Greece, the Scottish independence referendum, Cyprus, Greece again, Brexit, and numerous others already forgotten. We have to go back 36 years to find the previous black swan, when the Fed led by Paul Volcker started raising the fed funds rate to break rampant inflation. To borrow from another well-known saying, experts have predicted 12 of the last two black swans.

A modified black swan: the grey swan

History shows the black swan as a discrete event appears to have little predictive value. It becomes more useful if viewed as a process. Important market declines occur when unsustainable imbalances build up in some part of the system. The decline begins when the unsustainable condition starts to break down and, importantly, continues over a period of time. During this period, there are many of what can be called "grey swans." The term "grey swan" is not new, but the definition varies considerably. For this article, it means events or processes that together have are part of a major market decline even though individually they do not have the outsized impact or unpredictability of a black swan.

At present the unsustainable condition is the growth of debt, co-dependently enabled by central banks. Codependency - a term borrowed from the world of addiction - is an apt description of the process, and described as follows:

Codependents often feel compelled to solve other people's problems. If they're involved with addicts, particularly drug addicts, they usually end up taking on the responsibilities of the irresponsible addict. Their behavior starts as a well-intentioned desire help, but in later stages of addiction, they act out of desperation.… the sober partner increasingly over-functions and the addict increasingly under-functions. This builds resentment on both sides, along with the addict's expectation that the over-functioning partner will continue to make things right when the addict doesn't meet his or her responsibilities.

The unsustainable accumulation of debt is enabled by the repression of interest rates and massive purchases of debt by central banks. It will break down and start to rebalance as lenders end at increasingly higher rates and stop lending to lower quality businesses and governments at rates they can afford. Creditors are the codependents, debtors are the addicts, debt is the addiction.

In the Great Recession there were numerous grey swans before the Lehman Moment. Here is a chronology of some of the important events:

MM/YY

Event

S&P500

03/07

Lenders cut off funding for New Century

1421

10/07

Market high

1527

01/08

2008 begins

1468

01/08

Countrywide market cap down 85%

1378

03/08

Bear Stearns rescued by JPM

1322

06/08

Lehman stock down 73% for year

1280

07/08

IndyMac fails

1267

08/08

Intermediate market level

1282

09/08

Lehman Bros. fails

1166

09/08

"bank run" on MM funds

1166

09/08

WAMU, largest thrift failure

1166

10/08

TARP free fall

969

03/09

Final market low

666

Click to enlarge

There were many other signs of deterioration in businesses near the center of the unsustainable leverage and debt situation as well. For example, Citigroup (NYSE:C) stock was down 72% by July 2008. If an investor was sensitive enough, there were enough signs of a crisis - grey swans - to take action to avoid the truly bad losses across the markets. As late as August 2008 the broad market was only down 12%. If the investor waited until after Lehman on 9/15/08, it was too late. Three weeks later the market was down another 28%:

Click to enlarge

Source: Yahoo Finance

The dot-com boom had a similar pattern without a black swan. The last S&P500 peak was around 1520 in August 2000. By March 2001 there were scores of 90%+ stock declines or bankruptcies, including boo.com, Free Internet, Infospace, pets.com,Webvan, Learning Co., Kozmo, and Books-A-Million. The S&P 500 was down 25% at that point, but investors who saw the accumulation of grey swans as a signal and took action avoided another 18 months and 30% of declines.

It is easier, of course, to see all of this in retrospect rather than real time. But the pattern is clear. An unsustainable imbalance grows in one area of the economy. Businesses close to the center of the imbalance begin to fail. Failures accelerate in number and spread to all areas of the market. Market declines accelerate to (usually) several selling climaxes. Prices take years to recover.

Where are we today?

Is this pattern unfolding today? If so, how far has it progressed? The unsustainable imbalance today is debt enabled by repressed interest rates and huge amounts of money added to the system by central banks. Grey swans will appear as interest rate increases, unsustainable systemic financial conditions, impaired central bank effectiveness, and most importantly financial deterioration or failure of entities near the center of the excess. Each reader will have to make his or her own assessment, but the accumulation of these events is troubling. In addition to many smaller examples, we have seen the following:

Summing up

The black swan as a single event is rare and by definition isn't recognized in real time. Grey swans, by contrast, accumulate over time, giving investors time to assess, assimilate, and plan. Thanks to the time element, is not important or even necessary to precisely pinpoint market turning points. As readers may recall, John Paulson, Jeremy Grantham, and other investing titans who foretold the 2008 crisis were years - not days or months - early, but still made fortunes for their clients.

In terms of market signals, the grey swan offers a real opportunity to get ahead of a market crisis that can set an investor back many years. The past eight years have anaesthetized us to bad news and the danger is that we will not wake up in time to recognize developments that signal a major turn in markets. The characteristics outlined here will help pick out true grey swans from the barrage of available information. Have enough grey swans accumulated to indicate a crisis? Each of us has to make our own determination, but current conditions require us to be vigilant against such a threat to our financial future.

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.