Black Swans and Stock Markets
You might wonder what the relationship is between Black Swans and the stock market? Now is a good time to find out as it appears that an entire flock of Black Swans have already flown in.
In Nassim Nicholas Taleb’s definition, a black swan is a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations. Many scientific discoveries for him are black swans—”undirected” and unpredicted. An event often referred to as a “black swan” is the September 11, 2001 attacks.
Another example is one which actually involved a series of black swan events. This being the meltdown of Long Term Capital Management which started with the Asian financial crisis of 1997. This event appears to be closely related to the challenges faced by the hedge fund industry today. Â
The term black swan comes from the ancient Western conception that all swans were white in color. In that context, a black swan was a metaphor for something that could not exist. The 17th Century discovery of black swans in Australia metamorphosed the term to connote that the perceived impossibility actually came to pass.
The relationship of black swan events and to the present day stock market is this. Most fund managers, and especially hedge fund managers, use complicated computer models to select and to manage investments in their portfolios. In many cases these models are so complex the fund managers using them do not fully understand how they work.
The mathematician “quants” who write the programs for these models are aware that black swan events can occur but rate the probability of such an occurrence as being so remote that the model basically ignores it. After all, if there is a one in one hundred million chance of an event or series of events happening the chance of that event happening in our lifetimes is so unlikely that we can consider it as impossible. Or can we?
The financial modeling programs are not programed to deal with the impossible. So what happens when the “impossible” happens?
Markets tend to blow up, that’s what. A number of leading hedge funds are down by 30 per cent or so only in August. A number of them have already filed for liquidation.
The credit markets are not supposed to “freeze” due to evaluation problems. In fact the financial models neatly side step the question of evaluation by marking prices of hard to evaluate securities “to model”. What’s that? The model makes up it’s own evaluation of what an investment is worth by using it’s own build in evaluation program rather than by going to market?
Yep. That’s what is does. But the trouble starts when the financial instruments actually have to be sold. Then the market evaluation must be used. However, in many cases there is no market evaluation because the underlying financial derivative or investment has been sliced and diced in such a complicated way there is no ready market for it.
If a buyer can not readily evaluate an investment he will either not but it at all (most likely) or he will offer a deeply discounted price. Either way the seller is stuck. If it is a stuck hedge fund manager he may have to halt redemption requests from investors as he can’t raise sufficient funds to pay out the requested redemption amounts. He may still have to sell off whatever he can just to raise enough money to stay afloat.
That means that he may have to sell off sound investments because the exotic ones have become completely illiquid. This forced selling can seriously impact the stock markets of the world. So can investments that can not be redeemed. Who wants to invest money only to be frozen in a bad investment? This is what happened to some of the Bear Sterns hedge fund investors who wanted out long before their investments become worth zero with the funds bankruptcy.
One or two black swans can implode our entire global financial structure. That’s how dangerously interrelated our financial markets have become. And guess what? One or two black swans have already flown in to say hello to our financial markets.
The meltdown of the sub prime home loan lending market was not supposed to happen. It was thought that the number of sub prime loans would remain a small percentage of the entire huge mortgage lending portfolio. But enter the black swan. As sub prime mortgages began to experience a high default rate the contagion began to spread to other loan markets.
Events that were supposed to not be able to happen, impossible black swan events, did happen. Of course the stock market was and will continue to be affected. A black swan fueled credit crunch can not possibility be good for stocks.
The potential for serious trouble in financial markets is very real. A defensive strategy of raising cash reserves is prudent.
