Black-Swan

Why Investors Don’t Need to Worry About Black Swan Events.

Black Swan events are often discussed and mostly dreaded in investing circles. They seem to come from out of nowhere and lead to a stock market crash.

But as you will see in this article, you don’t need to be afraid of a Black Swan event. You’ll also learn how to protect yourself from a stock market crash.

What is a Black Swan Event?

According to Investopedia, a Black Swan Event is:

“…an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, their severe impact, and the widespread insistence they were obvious in hindsight.”

Nassim Nicholas Taleb is credited for coining the term “Black Swan.” He was a finance professor, writer, and former Wall Street trader for 21 years. 

Let’s examine the “extreme rarity” aspect of a Black Swan Event,

How rare are Black Swan Events?

Have you seen quotes like this: “We’re living through a once-in-a-generation event.”

I hate to tell you, but we’re not.

In fact, the Covid-19 market crash was the 3rd “Once in a generation event” in the past 20 years. (Generations must be getting shorter.) The others, of course, were the housing crisis (which was caused by the subprime CDS (collateral Debt Swaps (derivatives)) and led to the GFC (Global financial crisis) in 2008-2009. Prior to that was the Tech Bubble in 2000).

What these events have in common is that the stock market (or certain parts of the stock market – tech, housing..) was in a bubble prior to the Black Swan Event. That is, the prices of assets had become extremely detached from the value of the underlying asset.

Prior to the Covid-19 crash was a period in the market generally referred to as “the everything bubble.

More on the importance of this in a minute.

Other Black Swan Events in history.

  1. Asian Financial Crisis (1997)
  2. The Dot-Com Crash (2000) (AKA: Tech Bubble 1.0)
  3. Global Financial Crisis(2008) (AKA: GFC)
  4. European Sovereign Debt Crisis (2009)
  5. Fukushima Nuclear Disaster (2011)
  6. Crude Oil Crisis (2014)
  7. Coronavirus (Covid-19) Pandemic (2020)

Some of these were narrow in effect – Fukushima for instance mostly affected Japanese stocks – while others are more global.

The focus here is on the US Stock market and as such, we will limit our discussion to items 2, 3, 6 and 7 above.

The Common Factor and Why you Don’t need to Worry About Black Swan Events.

The common underlying pre-condition in each of the market crashes related to these events is an asset bubble.

The Fed creates them, they burst (due to an “event”) and then the Fed re-inflates them. For better or worse (or should that be: better, then worse?), this is the modern economic cycle.

Market bubbles are a lot like life – we can’t control them, but we can control our reaction to them.

Why You Don’t Need to Worry About Black Swan Events.

The reason investors don’t need to worry about seeing potential Black Swan events before they happen is because you’ll see warning signs of the bubble before it hits the pin, regardless of the pin.

If you see the bubble, the nature of the ultimate event that leads to its collapse doesn’t really matter

The Buffet Indicator

One of the best ways to spot an overheated stock market is by comparing the Market Cap to GDP, the so-called Buffett Indicator. This has long been one of Warren Buffett’s indicators and as you can see in the image below, it works.

A recent chart of the "Buffett Indicator"

The Wilshire Total Market is the index most commonly used as a proxy for “market cap” of the whole stock market.

What this means in layman’s terms is that the entire universe of stocks (more or less) is worth more than the entire output of the United States economy when the Wilshire line rises above the GDP line.

Another way to visualize this is by plotting the value of the Wilshire Total Market Index as a percentage of the GDP. That’s what Jill Mislinski of Advisor Perspectives has done here:

Stock Market Cap to GDP, May 2020

The idea being that a value of 100% represents a fairly valued stock market. 80% would represent a stock market that was 20% undervalued.

This shows that even after the March 2020 plunge  stocks are once again back to a Whopping 156% of the value of the total GDP. (And that GDP, mind you did not include the Q2 results of the economy being put on hold for quarantine!

This means that by the Bufffett Indicator (Market Cap to GDP), the stock market is still 56% overvalued.

The Shiller PE Ratio.

Another very helpful, long-term indicator of when the market is overvalued is the Shiller PE Ratio. Named for the Yale economist who created it (Robert Shiller), the shiller PE Ratio is the Cyclically Adjusted PE (or, CAPE) Ratio of the S&P 500 as a whole. 

Here’s a snippet from 2020 (courtesy of https://www.multpl.com/shiller-pe)

Chart of the Shiller PE Ratio, May 2020

The 10-second version of the Shiller PE Ratio is this:

The S&P 500 averages around a 15 PE. When it’s over 20, it is overvalued. Under 10 is undervalued.

The further above 20, the greater the likelihood that the stock market is in or heading towards a bubble. You can see this most prominently in the extremes noted above, namely; “Black Tuesday” and (un-named here) dot com bubble of 2000. I encourage you to read Shiller’s seminal book, Irrational Exuberance, for a more complete explanation of the concept.

What to Do? (How to Handle the Black Swan)

Use of a trailing stop-loss order is perhaps the best tool in these cases.

Put trailing stop-losses in place, and when that swan swoops in to pop the bubble, you’ll be out and in the clear.

Of course, this only works provided there is enough liquidity in your investment. In other words, it won’t help you much if you’re investing in penny stocks, but then that’s speculation not investing and you wouldn’t do that anyway if you’re reading this site, right?

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