The Black Swan Theory, or the theory of black swan events, is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight.
The theory was developed by Nassim Nicholas Taleb to explain:
» The disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance and technology
» The noncomputability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities)
» The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs
Much debate has surrounded Taleb’s 2001 book, Fooled By Randomness, and his 2007 follow-up book, The Black Swan. Taleb regards almost all major financial events, scientific discoveries, historical events and artistic accomplishments as “black swans” — undirected and unpredicted, including the rise of the Internet, the personal computer, World War I, dissolution of the Soviet Union, and the 9/11 attacks.
In my opinion there is no such thing as a Black Swan event. While I will restrict this discussion to financial market events, I would argue that every historical event, included those noted above, could have and were predicted by respected scholars, economists, etc. This certainly includes the financial crisis of 2008-2009.
According to Taleb, a Black Swan is an event with the following three attributes:
» It is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility.
» It carries an extreme “impact.”
» In spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.
This last point is key to his theory — the idea that people (you and me) try to rationalize these high-impact events after the fact, by, in hindsight, searching for the root causes. We say, of course the stock market crashed in 2008-2009, the mortgage market with all the derivatives, leverage, speculation, etc., was bound to collapse, and with it the entire financial system.
I would turn this last point on its head to refute his arguments, and his Black Swan theory in total — the fact that there were clear signs of an impending disaster were clear, glaring and were, in fact, predicted by many well-respected experts. The fact that the majority of people ignored these warnings does not change the fact that the crisis was predicted by many. Therefore it was not a Black Swan event (although he claims it was).
The only events that can “cause” a serious correction/crash in stocks are events that occur when market valuations are overextended. The magnitude of the event — its seriousness in terms of political or economic impact — is immaterial. For example, if the exact same event occurred when market valuations were extremely low, the market reaction to the event would be minimal, or could possibly even be a rally. Therefore it is not the event, but the market characteristics present when the event occurs that is the critical factor. Valuations are highly extended right now, so any event, regardless of its importance, could be the trigger that sets off a correction/crash.
Stock market valuations are hyper-extended right now. I have already written about this in my previous two articles: This Earnings Season, NASDAQ Composite Is the Index to Watch and Russell 2000 May Be Early Indicator for Market Direction. To reiterate: The NASDAQ Composite Index is currently trading at 35X earnings and the Russell 2000, even after more than a 10-percent correction from its March 4 high is trading at 95X earnings. These valuations are extreme by any measure, placing the market in a very precarious position. Any event, regardless of how historically important it may be (or may not be), could serve as a trigger to send the stock market into a correction or a crash.
There are plenty of others predicting at least a serious correction, if not worse, right now, so if we experience one of these, it will not be a Black Swan event. I am predicting a correction or possible crash right here, right now, so it will not be a surprise to you if it comes.
Taleb would likely argue that if you don’t listen, it won’t matter that you were told because it will still be a surprise. I hope you are not surprised. I hope you take this warning to heart and mind, along with warnings from many others with national profiles, and make appropriate changes to your portfolios.