An Unusually Large Herd of Grey Swans

Events that can have a significant impact on the economy and capital markets have become known as swans of various shades thanks largely to Nassim Taleb’s book, The Black Swan, in which Taleb reminded us of Karl Popper’s criticism of inductive proof in science. A black swan (per Taleb) is an unanticipated, rare event. A grey swan (per many), is an unlikely event that is only minimally anticipated.

The best way to describe the current market, then, is to say that there is “an unusually large herd of grey swans” about. It refers to an outcome–a single impactful event–that is quite possible and therefore should be anticipated but it is not because too much attention is focused on the low probability of each separate event occurring instead of the collective likelihood of any one event occurring. I guess it is another way of saying that we miss the forest for the trees. As the number of grey swans in the herd increase, the likelihood of an impactful event increases.

The conditions that make this market a herd of grey swans are as follows: The market is priced for perfection as the Graham-Shiller CAPE and Tobin’s Q ratio are near all-time highs, by which we can infer that investors are sensitive to momentum and are ignoring risk and values. At the same time, the number of low-probability events that could cause a major correction also seems to be high. This environment is different from one described by the adage that “rising markets climb a wall of worry” because those environments start at low prices relative to fundamentals. That is, there is always more worry immediately after a correction–such as in the first quarter of 2009–than after a significant rebound, which is where we stand right now (2/25/12) with the S&P 500 just 15.4% from its all-time high.

The large number of grey swans include (not in any particular order):

  1. a sovereign debt default (either legally or de facto) by any one of Italy, Spain, Portugal, Japan, France, Ireland, or some other country not yet on the radar in addition to the default that has already occurred in Greece;
  2. austerity throughout Europe and the US in order to pay the bills for previous overspending (US and Europe) and low productivity (Europe);
  3. a collapse of the European Union or the Euro
  4. a surge in inflation around the globe;
  5. a war with Iran and its supporters or instability due to Iran’s development of a nuclear weapon (the collective probability of this must be close to 100%);
  6. a Chinese economic implosion as inordinate government command of the economy cannot be sustained;
  7. a collapse of the Russian banking system;
  8. unrest in the US as a significant amount of promised public-sector post-retirement pension and health benefits must be cut or eliminated in order to balance state and local budgets;
  9. significant instability in the Muslim world (excluding Iran) for many reasons, but particularly as US influence declines with US military withdrawals;
  10. something unexpected from North Korea;
  11. a less-than-peaceful transition of political power in the US in November; and
  12. a large natural disaster–earthquakes, tsunamis, droughts, volcanic eruptions–(for example, see Nova’s excellent and recent “Deadliest Volcanoes.”  A preview:

Separately, these events are not black swans; they are grey swans–low probability events but not rare ones like black swans. Together they are a herd of grey swans where only one event need occur to cause major problems; imagine if two occur. On the surface most appear to be independent events, but what is to stop North Korea from doing something stupid if China is focused on a war in the middle east or its own economic collapse? What would happen to economic activity and political stability if lingering ash from volcanic eruptions caused a significant reduction in food production? If we add a black swan event that no one is even thinking about, the outcome could make us nostalgic for 2008-2009.

In the very long run, I am a rational optimist. In the near term, I am a rational zoologist. If you can buy cheap insurance, do so. On that note:

While the Japanese debt bomb isn’t expected to go off tomorrow, Japanese CDS is now 50% higher than where it was a year ago. Wall Street involvement in the Japanese debt market has grown in the last few years, which could bring increased pressure on the government to try and solve its debt dilemma. Eventually, though, the Wall Street bond vigilantes could drag Japanese bond yields up to levels that could cripple the government’s  ability to pay off its debts, setting the stage for one of the most prolific sovereign debt defaults in history.


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