The Black Swan

The Black Swan is a 2007 New York Times bestseller by author Nassim Nicholas Taleb. The subtitle of the book is The Impact of the Highly Improbable. The book’s goal is to educate readers on the extreme impact that rare and unpredictable events have had throughout human history. Taleb, a former options trader, focuses part of the book on the impact that black swan events have had on financial markets. His takeaway is that we should not try to predict unpredictable events. Genius! Our takeaway is that a great catchphrase for a title can turn an otherwise dry and monotonous book into a bestseller. To be fair to NNT, he’s an original thinker and we thoroughly enjoyed his first book Fooled by Randomness. Much of our process is designed around the behavioral finance issues that NNT addresses in his books. We simply found the Black Swan to be a continuation of Fooled by Randomness, not an epiphany of a previously undiscovered behavioral bias. As a quick refresher, the catchphrase “black swan event” is a metaphor that describes an event that is unforeseen but has a major impact on our lives. NNT’s observation is that after the fact these events are explained as obvious and predictable. This hindsight bias leads humans to believe they possess a higher forecasting ability (explanatory power) than they actually do. For example, people that have never mentioned the word pandemic before now say this pandemic should have been anticipated. The expression “black swan” is a great visual. For centuries humans assumed all swans were white because that’s the only color swan anyone had ever seen. Then explorers in a remote area of Australia discovered black swans. Although ornithologists never suggested the existence of black swans, with hindsight bias, ornithologists responded to this discovery by pointing out the foolishness of anyone who assumed all swans were white. The term “black swan event” has a negative connotation. The COVID-19 Pandemic is often referred to as a black swan event. By definition, black swan events are unpredictable. Therefore, rather than predict, we’ve decided we will muse about a potential black swan event for domestic equity markets. Also, rather than focus on the negative consequences of black swan events, we will focus on potential positive consequences. Let’s start by taking a deep breath and observe how the S&P 500 has performed during this pandemic.

After dropping 33.9% in rapid fashion, stocks bounced 27% off the March 23rd lows in a similarly rapid fashion. Stocks are down 10.5% YTD and currently are at the same level they were at in June of last year. Another way to think of this is that stock investors have lost about 10 months of returns. While we expected the initial recovery in stocks to be V-shaped, the swiftness and magnitude of this bounce has exceeded almost all expectations. So, what’s going on? If stock markets continue to shoot higher maybe this is how investors will explain, with hindsight bias, the obvious reason for this black swan event; when the government put record amounts of stimulus into an economy that was only temporarily impacted, but structurally sound, when the temporary obstruction was removed, of course, the economy was greatly overstimulated.

Roughly 3 trillion dollars has been inserted into the economy. That’s a crazy number. That is multiples higher than any previous stimulus package. Astonishingly, there is a strong likelihood of another similar stimulus package soon. The federal reserve has cut the Fed Funds rate to zero and expanded its balance sheet to a point that is literally “off the charts”.

No one seems to be asking the question of what happens if a therapy or vaccine is developed in a quicker fashion than anticipated? Or if for whatever reason this virus fades faster than anticipated and our lives, and the economy, return to a somewhat normal existence in a much shorter time frame than anticipated? What happens to the trillions of dollars we are pumping into the economy in this scenario? Consistent with black swan events, in hindsight, it would be explained as obvious and simple. The trillions of dollars put into the economy were intended for non-discretionary spending. Its purpose was to float the economy until people could start working again. Since people went back to work much faster than anticipated, the magnitude of this monetary stimulus was not needed to pay rents or buy food. Instead, it was used on discretionary spending. This created a short-term economic boom and a spike in inflation. As we caveated, this is not a forecast but rather a musing about a possible outlier scenario that is not being talked about. In the immediate term, we expect stocks will continue moving inversely to the pandemic. Reality is that reopening the economy is going to be a trial and error exercise, despite no shortage of expert opinions on what is going to happen. If things go better than expected, stocks will go higher. Of course, the opposite is also true. It’s going to be a very interesting few weeks, The GreenPort Team