What Impact Have Black Swan Events Had on the S&P 500 Since 1982?

Black Swans are large impact, hard to predict rare events beyond the realm of normal expectations based on experiential knowledge. Truly, there have only been two black swan events of that proportion in the past 26 years - and that was the stock market crash in 1987, and (at least for us Americans isolated by two oceans) was the collapse of World Trade Center in September 2001.

The Iraq war in 1990 was not a black swan because we know about wars. Recessions too, are not unknown to us. We had a mild recession in 1989-1990, and again in 2001. Not even bear markets are unknown to us, so not even the 51% S&P 500 correction of 2000-2002 could be considered a black swan event. At best, since 1987, these have all been "Grey Swan" events - to borrow a coined phrase.

Evolving Systemic Risks in Credit Markets

However, there have been some disruptive systemic risks to the global financial system since 1987, beginning with the Asian Contagion of 1997, as well as the Russian default and LTCM debacle in 1998. Systemic risks to the global financial system like we had in 1987, and the close calls we had in 1997 and 1998 hardly border on being unquantifiable and unknowable events fraught with "Knightian Uncertainty."

By and by, the impact of the Asian contagion on the S&P 500 was 15% in 15 days, LTCM was 22.5% in 31 and 57 days (a double-bottom effect). By way of comparison, the S&P 500 has dropped 16.9% in 16 days since December 27th, and 21% in the 69 days since October 11, 2007 as of January 21, 2008.

While, TO DATE, the stock market declines have been comparable to the 1997 and 1998, and a relief rally is highly probable this week, there is still no solution in sight for the intermediate outlook. There were quick fixes back then, but as of this moment, I know of no fiscal or monetary stimulus or tool that can "save the day" - other than to mandate a freezing of the credit rating downgrades like the gov't did with the ARM resets in December 2007.

No, after overnight plunges in the global equity markets on Monday, the feeling that I am left with at the end of the day is a bit like being stuck in Jean Paul Sartre's existential play "No Exit."

This is just something the investment community is going to have to stomach largely without the safety nets of a Federal Reserve or U.S. Government because the problems lie in the shadow banking system - outside of the realm of the traditional banking system. The investment community at large will live to see another day, but they will have to face the music of forced asset sales and liquidations periodically as episodic credit rating downgrades and credit defaults are triggered throughout the year.

The Shadow Banking System is Still Fraught with Knightian Uncertainty and Black Swan Potential

If all the U.S. economy was doing right now was going through a recession-like economy - that would not be such a problem. But the matter is hardly as simple as that. The matter is severely complicated by credit crunches in the term markets, hoarding of money by banks, runs on the shadow banking system, 100's of subprime lenders blowing up, corporate credit rating downgrades and defaults - and particularly at risk in Q1 08 are the bond insurers ACA Capital, Ambac, MBIA.

These are not exactly household concepts or names familiar to most people. I did not know their names until last month. If you are not a full blown credit expert you might have some difficulty understanding why the S&P 500 index is off 5% overnight Monday and down 20.8% from its October 11, 2008 peak 14 weeks later. The plain fact of the matter is that many market participants are being taken by surprise. Even the credit experts themselves are having difficulty comprehending the magnitude of the potential systemic risks. "No one knows when the end may be in sight, including the raters," said Richard Larkin, a municipal bond analyst at JB Hanauer & Co. "The rating agencies have lost as much credibility as the bond insurers."

Credit Rating Downgrades on Bond Insurers

A few weeks ago, Peter Plaut at Sanno Point Capital Management said this about bond insurers:

The outlook for rising credit losses doesn't bode well for the outlook for the financial guarantor [bond insurers] and mortgage insurers in upcoming quarters. The rating agencies may also need to adjust ratings to reflect reality... The ability of the financial guarantors to raise capital will determine the outlook for hundreds of billions of corporate, municipal and mortgage debt.

"Nobody knows how much capital is really needed to recapitalize this (bond insurer) business properly,'' said Ed Grebeck, CEO of a debt consulting firm Tempus Advisors.

Credit Rating downgrades "can and do lead to the immediate liquidation of certain CDO's" notes Bill Gross:

The inability to rollover asset-backed commercial paper does and has led to the liquidation of SIVs...[there] have been and will be similarly vulnerable to "Jimmy Stewart-like" [bank] runs as the [bond] insurers that theoretically stand behind [the CDO's] are themselves downgraded to less than Aaa status. The withdrawal of deposits from our new age shadow banking system has frightening potential consequences.

Credit Default Swaps

The damage from prospective CDS defaults and deteriorating credit generally could make the housing debacle look like a warm up. Many corporate credit professionals don't understand this nor are they prepared to absorb the resulting losses and accounting restatements - said Jerry Flum CEO of Credit Risk Monito.

In his January newsletter, Bill Gross wrote:

Credit-default swaps are perhaps the most egregious offenders" in today's banking system. Our modern banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever.

The market for outstanding credit-default swap contracts grew to $45.5 trillion during the first half of last year from $632 billion at the end of June 2001, according to the International Swaps and Derivatives Association. Bill Gross said:

Assuming default rates on corporate bonds reach historical averages of about 1.25%, $500 billion of credit-default swap contracts will be triggered, causing losses of $250 billion to the party that wrote the contract after accounting for the recovery value of the securities.

The point is that as capital gains and capital losses slosh from one side of the shadow system's boat to the other...Fine, but the losers in many cases will not be back for a return match. Much like casinos depend upon a constant stream of willing gamblers believing that this is their day, so too does Wall Street. They will likely not be back.

Why Was the S&P 500 Down 5% Overnight Monday?

The short answer is forced asset sales. On Jan. 21, Bloomberg news reported that ACA Capital (a bond insurer) is in the process of liquidation - and it was given until Feb. 19 to unwind $60 billion of credit default swaps it can't pay.

The 5% overnight swoon in the S&P 500 equities on Monday was most probably the result of "forced selling" by banking institutions in response to the "fast deteriorating counterparty creditworthiness" that is spilling into the equity markets. As Toby Nangle at Baring Asset Management put it, "ACA is an important case to follow because it shows how the banks' react to fast deteriorating counterparty creditworthiness."

If the 5% overnight drop in the S&P 500 on Monday was any indication of what is episodically to come as the drama in the CDS market unfolds, then there will be plenty left to haunt equity investors after Monday as the two largest bond insurers MBIA and Ambac will be scrutinized by the credit rating agencies for potential credit rating downgrades beginning next month. According to a January 18th Bloomberg note, these two bond insurers have a more than 70 percent chance of going bankrupt, as credit-default swaps show.

"In this market, a downgrade could mean the beginning of that company's eventual collapse, explains Matt Fabian, an analyst with Municipal Market Advisors in Westport, Connecticut. "The ability of Ambac to survive as a going concern is now in material jeopardy," according to Rob Haines, an analyst at CreditSights bond research.

Losing the AAA stamp would cripple the bond insurers' business and throw doubt on the ratings of $2.4 trillion of debt the industry guarantees, causing as much as $200 billion in losses, according to data compiled by Bloomberg.

Where the S&P 500 is Located on the Weekly Chart

With the S&P 500 having corrected 21% from 1586 to 1255 overnight Monday, it now sits atop the August 2005 high at 2006 and the October 1999 low at 1242. Given that the Black Swan-Like events evolving in the Shadow Banking System and Credit Default Swap markets - it seems unlikely that this will be just another generic 20%-22% correction like we had in October 1990, and again, in October 1990. No, by the time it is all said and done, its seems far more probable that the correction at least test the 1990 trendline support sloping into the October 2005 low at 1172 in Q1 08.

Quite possibly the correction will approximate the 29% declines off the Sept 2000 high and May 2001 highs. This would take the S&P 500 all the way back to the April 2005 Year low. The extended downside targets would be the 50% retrace to the 2002 year low at 1104-1106, and the October 2004 low and March 2001 low at 1088-1090. That essentially would give back all the gains during the explosion of subprime lending era of 2004-2006.

Since 1990, bearish impulses in the S&P 500 tend to exhaust between 15% and 30%. Having already declined 21% from the peak, punctuated by Tuesday's climactic 5% forced asset selling (rather than capitulation), investors should expect some sort of short to intermediate term bottom on the daily charts is near at hand.

However, episodic events like Tuesday's 5% declines can be expected to happen again as risks of credit defaults increase at amongst financial institutions with significant counterparty risks. Hard support on the weekly chart will remain in the 1088-1172 zone for the foreseeable future in the first half of 2008, and it would not be unrealistic to test these lower support zones before the S&P 500 can build a base to start over again.

Comments

[ain't no fo...:]

John, belatedly, I congratulate you on a magnificent article. You will be one of the unrealized and unheralded "heroes" who recognized the impact of the black swan as it occurred, while most others looked the other way.

2008 Sep 22 11:18 AM