The term "Black Swan" became extremely popular after Nassim Taleb introduced it in his book and the 2008 meltdown graphically illustrated the concept.
As it became part of the Wall Street lexicon, the term was abused to the point where all sorts of low probability scenarios were referred to as "Black Swans." This irritated Taleb to no end as it missed his main point - the Black Swan as he described it is unpredictable, the Rumsfeldian "unknown unknown" that you don't see coming.
The idea of the Gray Swan - a riff on the Black Swan - is a potential catastrophe that is not only foreseeable, but likely to occur at some point given a confluence of drivers. The challenge with a Gray Swan is that you don't know the actual timing. There is just a strong sense it could happen sooner or later. Many potential macro-level crises fit the Gray Swan profile, since it is so hard to know when a bubble is going to burst, a credit cycle is going to break down, or inflation/deflation hits a tipping point, etc.
Related to the Gray Swan is the "fat tail," which refers to a higher than expected chance of an extreme outcome. In a "normal" distribution the outliers, or "tails" - the lines tapering off to the left and right of the bell curve - are thin, meaning that the probability of outlier events is low. When the tails get "fat" it means the chance of something crazy happening is higher than one might expect.
Right now we see a lot of tail risk in concert with gray swans coming home to roost. Take the ongoing hard landing in China, for example, which bears with it (no pun intended) all kinds of knock-on effects. Or consider that Europe's problems are not solved, and may be about to worsen as the impact of China slowdown hits Germany (the world's third largest exporter) … and then of course there is the Senkaku Islands stuff and a weakening Japan …
You can see how many fat tails and gray swans there are in play just by glancing over some recent headlines:
- In Spain, economic crisis fans Catalan seperatism (Reuters)
- Germany's big worry: China, Not Greece (Reuters)
- Eurozone Flash PMI Awful (Business Insider)
- FedEx Warns on Slowing Global Trade (Financial Times)
- China factory output lowest in 10 months (Business Insider)
- Beijing hints at bond attack on Japan (Telegraph)
- Chinese General: Prepare for Combat (Washington Free Beacon)
In addition to the above, you have Western central banks (the ECB and the Fed) that have essentially fired their big cannons (in psychology terms) and are thus not well positioned to support overbought, overextended markets.
Is it possible that markets grind higher from here? Yes. Is it possible that the major U.S. indices (Dow, S&P 500, Nasdaq, Russell) correct sideways, through time, rather than downward, through price? Certainly it is.
But it is also possible that the primary driver for higher equity prices the past few months - stimulus anticipation - has now been removed, creating potential for sharp downdraft …
A key point here is that the probability of a move should also be considered in the context of magnitude. Strong likelihood of a small, modest move is not as interesting as lower likelihood of a large, powerful move.
To wit, an 80% chance of winning one dollar is not as interesting (or profitable) as a 20% chance to win $10. Odds and probability must become the trader's trusted companions. When you seek big waves instead of little wavelets you spend more time searching and trying, but you also get much longer and bigger rides on the big waves you do successfully catch.
We remain skeptical that QE will do much at all for the U.S. economy, and even more skeptical that various major currencies will maintain their strength against the dollar. Fat tail risks are building now, and they work in favor of a larger than expected "risk off" market correction as Western markets are so priced for complacency.
Our highest conviction trade, and this should be no surprise as it hasn't changed much, remains short the Aussie …
The Australian dollar is tanking today on the ugly data from Asia and Europe. Once the trend really gets underway, we hope to find a good pyramid spot or two (or three) on the trip below par and possibly all the way back to 90 cents (or even lower) …
In addition to AUDUSD we have an assortment of attractive short positions on and seek to add more incrementally. The ECB's OMT and the Fed's infinite QE may prove to have been twin peak points of a sort with sentiment and irrational exuberance heading into decline after their climactic introduction.