I’ve always been a huge fan of Nassim Taleb, author of the often-referenced book “The Black Swan.” In 16th century Europe, it was presumed that all swans must be white because every historical instance and record confirmed that this was true. And so it was, until 1697 when Dutch explorers discovered black swans in Western Australia. The analogy here is that you can have thousands upon thousands of observations confirming that all swans are white, but all you need is one black swan to prove that they are not.
The Black Swan is the outlier which defines history. It is the highly improbable event which has significant consequences, and which is only explained after the fact through the narrative of the moment. The Black Swan is the disruptor to everything one believed to be true. It is something that we can’t calculate the probability of, nor predict with any degree of certainty.
However, while it is impossible to predict what or exactly when the extreme outlier Black Swan presents itself, there are conditions that make it more likely to appear than not. In financial markets, those conditions are relentless stability and the resulting hidden buildup of risks that results from it. The more market participants believe in one thing (that all swans are white), the more risk is taken to take advantage of that perceived truism. At some point, this hidden buildup of risk explodes, and the Black Swan breaks all prior conceived notions of how the world works.
From that perspective, this is a highly troubling environment. Markets have been absurdly boring. Bond yields haven’t spiked despite reflation hope. Emerging markets have been on a tear, and volatility in the S&P 500 and in the small-cap Russell 2000 is quite literally at all-time lows. This has been the most peacefully quiet (and boring) stock market in history.
This is also the most dangerous and interesting market at the same time. The white swan is low volatility, whereby day after day we are reminded of just how little stocks move. Every single minor dip is immediately bought. And unquestionably, this has caused more risk-taking in short volatility strategies, and a degree of overconfidence that stocks are destined to continue to be high return vehicles.
What will cause a severe volatility spike? I have absolutely no idea. Hurricanes can be created by butterflies flapping their wings in chaos theory, so who is to say that an obvious reason is needed for stocks to breakdown? All we can say is that something remains off here. While the Fed has been raising rates on the short-end, the yield curve is near the flattest it’s been during the expansion. This isn’t exactly what one should see if all is well.
I recognize it feels like everything is awesome, and stocks are bullet proof. But equities are not a stable money market vehicle. Just because volatility is at extreme lows does not mean there isn’t severe risk of losing a lot of money in the future. On the contrary – it is exactly because risk appears to be eradicated that risk is likely to explode higher and for more than just a few days.
Don’t hope for a boring market, as they tend to be the most dangerous. Instead, prepare for the highly improbable by taking on less risk where you can. All you need is one Black Swan, one observation, to change everything. We are inching closer.