Remember the Black Swan?

The 2008 financial crisis was called a “Black Swan” event by finance professor Nassim Taleb.  In his eponymous book, Taleb defined a Black Swan as an extremely difficult to predict event or occurrence that deviates far beyond what is normally expected.  The term derives from the old world belief that all swans had white feathers, a collective assumption abruptly upended 1697 when Dutch explorers found black swans in Western Australia.  Imagine their surprise.

Some statisticians called the 2008 Black Swan a once-in-a-millennia event.  But wait, didn’t we have similar statistical market anomalies on Black Monday in 1987, and on September 11, 2001?  Not to mention in October, 1998 when “Genius Failed” and Long Term Capital Management’s quantitative risk models blew up?  Since the mid 1980’s, it seems as though the “once-a-millennia” Black Swans event happens about once a decade.

We note that the last Black Swan was nearly 10 years ago.

The VIX index shown above, also commonly referred to as the “Fear Gauge,” is a measure of the implied volatility of at-the-money options on the S&P 500; essentially the markets expectation of volatility over the next 30-day period.  The VIX is currently trading at 11, an extremely low level not seen since 2007.  This reflects a great deal of complacency in the markets.  It never ceases to amaze us at Weatherhelm just how short the collective memory can be.

Given uncertainty surrounding the new administration’s economic, regulatory and trade policies, a Federal Reserve that has recently come to life raising interest rates and declining corporate earnings for 8 consecutive quarters prior to the Q4 2016 reporting period, why are market participants so sanguine about their investments?  Uncertainty, almost by definition, should create volatility.

As the chart below indicates, there is a tremendous correlation between real growth in NYSE margin debt (borrowings by investors to make equity investments) and S&P 500 levels.  As you can see, debt levels and the S&P 500 rose in relative sync into the two most recent bear markets, the Internet Bubble of 2000-02 and the Financial Crisis of 2008-09.  Does today’s situation seem to bear (pun intended) any resemblance to those periods leading up to the last two bear markets and recessions?  Given that markets have essentially gone straight up since March 2009, wouldn’t you think the demand for “insurance” would be greater than the VIX Index implies?

Sophisticated investors often use put options on broad indices like the S&P 500 to hedge portfolio exposure.  This “portfolio insurance” is trading at historically low levels while at the same time headlines are shouting “DOW 20,000” and most broad stock indices are at or near record highs.  At Weatherhelm we remain invested, hopeful that increased economic optimism will result in buoyant equity markets and another year of gains like those we have recently experienced, but we also remember the Black Swan and are acting accordingly, hedging our portfolios with inexpensive insurance.

Do you remember the Black Swan?  What is your advisor doing about it?

As always, we appreciate your comments and thoughts, welcome an open discussion, and remain steady at the helm.

Clark Kastner                                                                     Stephen Lulla                                                                    Kristina Ickes