by Robert Rapier, Investing Daily
Article of the Week from Investing Daily
At this point, you have surely heard the phrase “black swan” used to describe the market turmoil that is being caused by the global spread of coronavirus (COVID-19). But generally, the person using the phrase doesn’t explain exactly what it means. So let’s review what a black swan is, what it isn’t, and how black swans can impact your portfolio.
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Although the phrase has been around for centuries, it was popularized in connection with the financial markets by the 2007 book The Black Swan, written by former Wall Street trader Nassim Nicholas Taleb. I read the book when it came out and highly recommend it.
The origins of the phrase come from an old European belief that all swans are white. People would use the term “rare as a black swan” to describe something seemingly impossible. But eventually, black swans were discovered in Australia. The seemingly impossible came true.
The author’s own experience revolves around the 1987 stock market crash. Prior to that single-day drop in the Dow of 22.6% (nearly double the 12.8% drop on Oct. 29, 1929), nobody would have guessed that such a huge drop was possible. Well, almost nobody. Nassim Nicholas Taleb became a very wealthy man on that day. More on that later.
Black Swans in the Financial Markets
Black swans are rare, outlier events that can’t be predicted beforehand, but which have huge consequences. The 1987 stock market crash, the 2008 financial crisis, and now the coronavirus outbreak all qualify as black swans.
You might be thinking: “Shouldn’t we expect black swan events?” In other words, shouldn’t we always expect the unexpected? That’s a fair question, but it misunderstands the intrinsic nature of a black swan event.
For example, we know that pandemics will occur. We just don’t know when they will occur, or how extensively they will damage the economy. The last one that seriously hit the financial markets was SARS in 2003, and the effect was short-lived.
As the coronavirus epidemic began to unfold in China in January, someone asked me if this could be “the next great pandemic.” I said it was too early to tell, but I added that the next great pandemic will probably look like this when it starts.
But we can’t predict beforehand how widely an outbreak like this will spread, how extensively it will spread, or how badly it will damage the global economy.
You simply can’t model a portfolio for black swan events. Because if you did, you could list numerous remote possibilities every year, and you would say “Because any of these remote possibilities could come to pass, your best bet is to remain in cash.” Black swans are by definition completely unexpected.
Current events are impacting every sector in varying degrees. I spent a few days at the Walt Disney (NYSE: DIS) park in Florida in early February. It was packed. The company has an incredible franchise with a great long-term track record. Today that park is closed because of coronavirus. Disney shares were trading just under $150 when the year began, but they dropped all the way to $92 as investors began to process the potential economic impacts of coronavirus.
This black swan event is seriously impacting the energy sector, airlines, cruise lines, restaurants, malls, movie theaters, and technology companies (because of reliance on Chinese supply chains). As the outbreak has grown, those sectors have all become much riskier. They will remain that way until it becomes clear that cases are starting to retreat. We are still a ways from a decline in coronavirus cases in the U.S.
So I will repeat something I have said nearly every week since January. Be careful bottom-fishing out there. We could be a long way from the bottom.
Making Money on Black Swans
Black swans in the financial markets are typically associated with events that cause steep market declines. So how did the author of The Black Swan become rich during the largest stock market drop in history?
There has been only one time in history that the stock market dropped 20% in one day. But imagine that you made many small, ongoing bets of a large decline. If every day you bet that the market would fall 20%, you would be wrong nearly 100% of the time. But if that one time paid back your small bet a million-fold, you could make a lot of money on that single winning bet.
For example you can often buy puts that are far out of the money for a small sum. You might think of it like buying a lottery ticket. You can apply your standard due diligence, but because the trade requires that something extraordinary happen in order to make money, most of the time, those puts will expire worthless.
But that is in fact what happened on Black Monday in 1987. It made Nassim Nicholas Taleb a wealthy man, and prompted him to write a best-selling book.
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