What’s a Black Swan?

Wednesday, March 11, 2020 | Jea Yu
What’s a Black Swan?

With the rapid worldwide spread of COVID-19 making hourly headlines, the term black swan is becoming a recurring theme. Black swan is used to describe an extremely rare and unpredictable event that triggers a perfect storm of catastrophic consequences. Famed statistician and author Nassim Nicholas Talab’s timely and prophetic book, “The Black Swan” was published in 2007 on the dawn of the millennium’s next black swan event, the subprime mortgage crisis. History has shown that black swan events are akin to the spark that lights a fuse in a warehouse already soaked in kerosene. In other words, the stress fractures were already building for a long time and waiting for the proverbial tipping point to finally collapse. We will compare the prior two bear markets derive the common factors and the unprecedented factors that led to the respective black swan event ushering in recessions and see how they compare to the current market environment. Investors are questioning if the coronavirus epidemic if the black swan that could usher in the next recession.

The 2000 Black Swan: Internet Mania

Coming off the 1997 stock market crash on the heels of the Pacific Rim crisis, Federal Reserve Chairman Alan Greenspan instituted a series of 11 rate cuts to sparking risk-on appetites that bolstered money flow into anything remotely related to this new thing called the internet. The Netscape IPO fueled the mad dash into internet companies spanning browsers, commerce, infrastructure, banking, storage and security. Even non-internet companies like K-Tel Records saw shares spike from under $10 upwards to $70s on the mention of adding e-commerce to sell albums. White-hot Internet IPOS were doubling and tripling right out of the gates. The day trading revolution hit the mainstream fueled by stories of overnight millionaires of making thousands with a few mouse clicks at home. This hype fueled euphoric market environment America drove the tech-heavy Nasdaq to the 5,000 mark. Greenspan coined the term ‘irrational exuberance’ in reference to the markets and instituted 11 rate hikes to slow down the economy. Sure enough, the internet bubble burst sending the Dow Jones and the S&P 500 index plunging over 50-percent ushering the first recession of the new millennium. 

Common factors: Stock market hits new all-time highs. Interest rate hikes after earlier deep rate cuts. High valuations, loose credit and heavy leverage. Alan Greenspan led interest rate policy.

Unprecedented factors: Internet companies as an industry was uncharted territory with questionably high valuations or operating models.   

The 2007 Black Swan: Sub Prime Mortgages

After the 9/11 terrorist attacks on the World Trade Center, Greenspan accelerated rate cuts to bring the Fed Funds rate to just one percent, the lowest rate since the 1950s. The low rates gave lower-income Americans access to adjustable-rate mortgages (ARMs) to purchase homes they wouldn’t normally be able to afford. This wasn’t a problem since they could continue to refinance the ARMs, or so they believed. As housing prices rose from the surging demand caused by easy financing, lenders were pushing the edge to earn big bonuses. The infamous NINJA (No Income No Job Application) loans were getting funded with no questions asked. This prompted waves of buying that sparked the housing bubble as leverage was used to purchase multiple homes for rental income. Wall Street found a way to offset the risk of subprime mortgages by packaging them with other investment-grade bonds securitized in a new product called a collateralized debt obligation (CDO). With the blessing of Greenspan and the rating agencies, these CDOs were sold to banks, pension funds, insurance companies under the guise of safety and secure financial products. Re-insurers like AIG make bountiful profits selling credit default swaps (CDS) on the CDOs to the buyers of these products as insurance against the unthought-of possibility of defaults. With the economy booming and housing market on fire, Greenspan started to raise interest rates in 2004, starting the ticking time bomb of ARM resets triggering in 2006.

CDOs Exposed

Greenspan retired in 2006, handing over the bubble to the new chairman Ben Bernanke. As sub-prime mortgage defaults rose sparking foreclosures, Wall Street played down the potential ripple effects since sub-prime was such a small segment of debt. As it turned out, the subprime portion of the CDOs were so highly levered that just a (-6 percent) valuation drop would wipe out all the remaining equity and trigger defaults. The ratings agencies knew that downgrading CDOs below investment grade could be catastrophic and continued to withhold downgrades as default rates exploded. Housing prices started to fall in 2007 as stock markets peaked out and accelerated to the downside. The black swan exposed the ridiculous levels of leverage exploited by banks and investment banks who kept these highly levered derivatives off the books in special purpose entities (SPEs). Bear Stearns collapsed but was bailed out through a JP Morgan acquisition backed by the Fed. However, Lehman Brothers was left to collapse ushering in the worst credit crisis since the Great Depression as credit markets locked up and sending benchmark indexes plummeting over (-50 percent) before bottoming out in 2009.

Quantitative Easing

Chairman Bernanke implemented the TARP bailout program to provide liquidity to the banks and open up credit market. Parlaying the same principles of TARP, he instituted a zero-interest rate policy (ZIRP) to bolster money supply and initiated two rounds of quantitative easing (QE) which was adopted by central banks worldwide to print over $10 trillion of money. This caused the Fed balance sheet to balloon to $4.5 trillion from $800 billion between 2007 to 2017. The Federal Reserve instituted quantitative tightening with rate hikes and monthly balance sheet reductions commencing in 2015. The objective is to return to normalization around $3.5 trillion balance sheet (reached $3.78 trillion). For still unexplained reasons, the repo market experienced disruptions causing the Fed to institute a $60 billion per-month balance sheet expansion through short-term repo purchases commencing in Sept. 2019. Many deem this as a stealth version of quantitative easing, which may have been the catalyst to fuel stock markets to all-time highs by February 2020, until the coronavirus epidemic stole headlines. 

Common factors: Stock market hits new all-time highs fueled by low-interest rates. Alan Greenspan’s interest rate policies. Credit and debt bubbles from excess leverage.

Unprecedented factors: Highly levered securitized CDOs. The unpredictability of ARM defaults. Investment bank insolvency. Global central bank intervention has been unprecedented. Quantitative easing is an unprecedented experiment that fueled the stock market recovery and surge.

The 2020 Black Swan: Coronavirus?

While patient zero for coronavirus can be traced back to December 2019, the equity market impact didn’t materialize until late February as stock markets pulled back from peaking at new all-time highs. The SPY peaked at $339.08 on Feb. 19, 2020 and proceeded to collapse (-16 percent) to lows of $285.54 in seven trading days in the wake of global supply chain disruptions and demand shock as consumer spending activity gets stifled. Major corporations like Apple (NASDAQ: AAPL) and Microsoft (NASDAQ: MSFT) pre-announced earnings shortfalls due to financial impacts of COVID-19 precipitated more companies to cut their guidance sending markets into a further tailspin as investors stampede into fixed-income instruments sinking the 10-year Treasury yield to unprecedented lows below 0.7 percent. Credit default risk rises with the duration of the outbreak. Electronics and automotive companies, in particular, are facings major disruption from raw material shortages and extended factory closures. Travel, dining and leisure companies are facing potential credit downgrades as consumers curtail activities to avoid the infection as nations implement large-scale quarantines. The coronavirus epidemic is shaping up to be a black swan event that could usher in a global recession if the pandemic lasts beyond the second half of 2020, especially if a second strain of recurrence emerges. Indications for a vaccine are still a year away. In future articles, we will examine the aftermath of black swan events and what can be anticipated this time around.




7 Forever Stocks That Are Never Bad to Buy

Investors thought 2021 would be a less volatile year. That narrative has run into some problems. Sure, all the major indexes are up for the year. And that’s despite the NASDAQ’s gut-wrenching 10% drop in March.

But many investors don’t feel much like celebrating. In fact, many are concerned about the liquidity that continues to be pumped into the stock market. In 2020, the pandemic flooded the economy with $6 trillion dollars of stimulus.

However, in the last few months, the Federal Reserve has introduced another $6 trillion into the economy. We would have stopped counting, but the math is pretty easy. It’s $12.3 trillion that has flooded into the economy.

Eventually, this is going to end badly. But timing the market is an imperfect science particularly when many investors are enjoying the game.

Fortunately, there’s a way to safeguard your portfolio without abandoning equities. That has to do with investing in forever stocks. Forever stocks aren’t magic beans. They don’t go up forever. But they are stocks that have stood the test of time. And investing in these stocks will keep your portfolio heading in the right direction.

With that in mind, we’ve put together this special presentation that showcases seven of these forever stocks. These are all stocks that are household names, but that’s kind of the point. You don’t need special knowledge. You just have to recognize that these are companies that consistently do right by their shareholders.

View the "7 Forever Stocks That Are Never Bad to Buy".

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