Black Swans

If you’re not familiar with the term, “black swan” typically refers to highly unusual and unanticipated events that disrupt the financial markets. Most swans are obviously white in color, but in rare occasions, a black one is hatched. The term, therefore, refers to low probability events. Of course, the term is typically used to refer to bad events. Nobody gets anxious when unexpected good events occur.

The question is whether investors can predict black swan events?

By definition, the answer is no. However, black swan events happen all the time. Why do some black swan events, like the two current ones (coronavirus and an oil shock), have an outsized influence on the markets whereas others have no meaningful effect at all?

The answer is fundamentals matter more than black swans. When fundamentals are improving, black swan events become short-term distractions. The power of improving fundamentals overwhelms the negative black swan event.

However, black swan events take center stage when fundamentals are deteriorating. We would argue that fundamentals must previously be deteriorating for black swan events to cause bear markets.

That has been true this time as well. Deteriorating fundamentals caused the black swans to have importance. There were plenty of warnings signs which investors totally ignored. Despite claims of the US economy’s strength, statistics reflected a meaningful slowdown. Consider the following facts that investors largely ignored:

1. US GDP growth had been below average for three straight quarters.

2. US leading indicators had been decelerating all during 2019.

3. Employment growth had slowed to only about 1.5% y/y.

4. S&P 500® corporate profits growth had slowed from over 20% to about 5%.

5. Small cap US stocks were in a deep profits recession.

6. Globally there was a full-blown profits recession.

7. Despite the notion that liquidity was everywhere, the US yield curve inverted, and global yield curves overall were extremely flat.

8. Short-term funding issues were mounting as the Fed needed to respond to problems in the repo market.

There are others we could point to as well, but the bottom line is that fundamentals were slowing or outright deteriorating, investors ignored the warning signs, and then the black swan events surprised.