Black Swan Events: The Reality of Unexpected Volatility

By Bud Kasper, CFP®, AIF®

April 6, 2020

The majority of Americans have probably never heard the term “Black Swan events,” especially when used in the context of an economic event. So why are we writing an article about this thing called a Black Swan event? It’s because Black Swan events create an unpredictable, negative, and many times catastrophic event that reaches beyond the typical situation. Sound familiar? Black Swan events potentially almost always create severe consequences even though they’re an extreme rarity. Once the event is over, and the severe impact is understood, there is generally insistence the event was predictable in hindsight! In 2007 Nassim Nicholas Taleb wrote a New York Times best-selling book on the subject titled The Black Swan: The Impact Of The Highly Improbable. So what was the origin of the name “Black Swan”? 

The Origin of the Name “Black Swan” Event

In his book, Taleb explains that before the discovery of Australia, people in the “Old World” (Europe) believed all swans were white. No one had ever seen a black one, never! Empirical evidence confirmed this unassailable belief, which was that no one had ever seen a black swan before. So when a black swan appeared, it challenged what this meant from a statistical perspective.

Black Swan events have three characteristics: First, they’re outliers that live outside the realm of regular expectations because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, despite its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making us believe that the event was explainable or predictable.

Examining Black Swan Events in History

September 11, 2001

Let’s think in terms of historical events that lacked predictability. Taleb’s example focused on the September 11, 2001, terrorist attacks in the United States. If the risks had been conceivable the day before on September 10, the Twin Towers would be standing today; the disaster averted as if it never happened. If the disaster had been predictable, there would have been fighter planes encircling the sky above the Twin Towers. Airplane cockpit doors would have been built so they locked and were bulletproof (which of course they weren’t at the time of the downing of the towers), and of course, New Yorkers would have stayed home from work. This is simply an example of a Black Swan event.

Other Black Swan Events

There are many others, including the 1997 Asian Financial Crisis, the Dot-Com Bubble 2001, and the 2008-2009 “Global Financial Meltdown,” which includes the Great Recession in the US. Let’s elaborate for a moment on America’s Great Recession. In the US, we saw the combination of the Great Recession with a second Black Swan event known as the subprime crisis. This is the time from November 9, 2007, to March 9, 2009, when the S&P 500 lost 56% of its value in 16 months.

The sub-prime crisis led to a devastating increase in thousands of foreclosures and bankruptcies of mortgages that caused millions of people to lose their homes as well as their life’s savings. Many consider it to be the most substantial economic decline since the Great Depression of the 1930s. Although its effects were global, especially in Europe, it was most pronounced in its origin, the United States.

Recessions Historically

The definition of a recession is a macro-economic event that refers to a significant decline in general economic activity. Based on this definition, one may ask, is a recession a Black Swan event? The answer is “No,” but that doesn’t mean that there can’t be overlapping events and characteristics similar to that of a Black Swan. Remember, Black Swan events are not predictable and are always devastatingly catastrophic. Additionally, the definition of a recession is two consecutive quarters of economic decline as scored by GDP (Gross Domestic Product). Recessions can, however, like Black Swan events, range from mild to catastrophic. In an examination of the Great Recession of 2008, we saw the Federal Reserve step in and attempt to curtail negative economic activity.

Great Recession Lessons

In February of 2008, President George W Bush signed into law the “Economic Stimulus Act.” This legislation provided taxpayers with rebates from $600 to $1,200, which they were encouraged to spend back into the economy. The plan also reduced taxes and increased the loan limits through the Federal Home Loan Program like those offered through Fannie Mae and Freddie Mac. The design of this last element was to hopefully generate new home sales and provide a boost to the economy.

Big Banks Tanked

The so-called stimulus package also provided businesses with financial incentives for capital investment. However, even with these interventions, the country’s economic troubles were far from over. In March of 2008, investment banking giant Bear Stearns collapsed after attributing its financial difficulties to investments in subprime mortgages, and JP Morgan Chase acquired its assets at a discounted rate.

A few months later, financial behemoth Lehman Brothers declared bankruptcy for similar reasons creating the largest bankruptcy filing in U.S. history. Within days of the Lehman Brothers announcement, the Fed Reserve agreed to lend insurance and insurance giant AIG $85 billion so that it could remain afloat. Political leaders justified their decision by saying AIG was “Too Big To Fail”! The government believed a collapse of AIG would further destabilize the U.S. economy and possibly accelerate fears that other major financial companies and banks could sustain similar collapses. In the early fall of 2008, President Bush approved the Troubled Asset Relief Program, better known as “TARP.” TARP primarily provided loans (with interest paid back to taxpayers) to troubled U.S. banks.

Big Bailouts

A massive $700 billion war chest was created to lend to mostly struggling financial institutions to keep them in business. The program would also enable the government to buy assets which they, in turn, could later sell, hopefully at a profit. Within a few weeks of the initiation of TARP, the government had spent $125 billion acquiring assets from nine U.S. banks in early 2009. Automakers General Motors and Chrysler used TARP funds for a combined $80 billion bailout, and aided banking giant Bank of America for $125 billion.

New Administration, Additional Stimulus

January of 2009 also brought a new administration into the White House with the inauguration of Barack Obama as President of the United States. However, many of the old financial problems remained on the new President’s desk. In his first few weeks in office, President Obama signed a second stimulus package that earmarked $787 billion in tax cuts as well as additional spending on infrastructure for schools, healthcare, and green energy. Whether or not these initiatives brought about the end of the “Great Recession” is a matter of debate. However, at least officially, the National Bureau of Economic Research (NBER) determined that based on key economic indicators, including unemployment rates and improvement in the stock market, the recession in the United States officially ended in June of 2009. 

Global Impact

Although the great recession was now “officially” over in the United States, America along with other countries, were still feeling the adverse effects of the downturn and did so for many more years. In fact from 2010 through 2014 multiple European countries including Ireland, Greece, Portugal, and Cyprus, defaulted on their national debts forcing the European Union to provide them with bailout loans and other cash investments. These countries, compelled to repay their Great Recession associated debts, implemented more significant austerity measures such as tax increases and cuts to social benefit programs, including health care and retirement programs, to repay their debts associated with the Great Recession. The recession also ushered in a new period of financial regulation in the United States as well as other countries around the world.

Combating a Repeat of the Great Recession

Economists have argued for years and still do, that it was President Bill Clinton’s repeal in 1990 of the Glass Steagall Act that contributed to America’s banking problems that led to the Great Recession. The truth is probably more complicated. However, the Glass Steagall Act, initially enacted in 1933 at the end Great Depression, placed strict regulations on banks to stabilize our financial system. With Glass Steagall banking regulations now dismissed through its repeal or minimally watered down many of the country’s larger financial institutions morphed to become significantly larger, which created the term “too big to fail!”

The government response to the repeal of Glass Steagall includes the passage of the Dodd-Frank Act. Dodd-Frank re-established and restored many of the U.S. government’s regulatory power over the entire financial industry and enabled the federal government to assume control of banks deemed to be on the brink of financial collapse. Dodd-Frank also established and implemented various other consumer protections designed to safeguard investments and prevent predatory lending banks who provided high-interest loans to borrowers who likely could have difficulty paying off their loans.

What About COVID-19?

So what’s the multi-million dollar question we are addressing today? Is Coronavirus COVID-19 a Black Swan event?” The answer is, “YES!”

It most certainly has met the requirement of being “unpredictable.” The results have been massively negative, and it most certainly has been, in our opinion, catastrophic! As well, the facts as they relate to the stock market’s decline has been historical! The S&P 500’s bull market in stocks officially ended on February 19, 2020. The bull market for the Dow Jones and the Nasdaq Composite ended on February 12, 2020.

The 2020 Decline

If the bull for the S&P had lasted just a couple of weeks longer to March 9, 2020, it would have recorded it’s 11th consecutive year of the bull market run. Our recent stock market crash of 2020 fell on the new “Black Monday” March 9, 2020. On that day, the Dow Jones Industrial Average recorded its most significant point drop ever of -2013.76. The previous record-setting decline occurred on Black Monday, October 19, 1987, when the Dow fell 508 points (-22.61%), closing the day at 1738.74.

Meanwhile, on that same day, the Nasdaq Composite and the broader-based S&P 500 shed -625 points and -226, respectively. This blew to smithereens their previous most significant single-day point decline. On a percentage basis, the NASDAQ gave up 7.29%, and the S&P 500 lost 7.6% for its 17th largest percentage loss of all time. Before the current correction, there have been 37 declines of at 10% in the S&P 500 since 1950. The good news is that a bull market rally completely erased every one of these drops that many times started back up again around three months after the drop.

Black Swan, recession, or correction; historically, it didn’t matter whether you stayed the course or were lucky and had cash to buy stocks as they declined. In many cases, using this as a way of building and perpetuating wealth stocks have provided returns rarely seen from any other asset.

Getting Help Never Hurts

At Modern Wealth Management, our plan is to learn from these past events so we’re prepared for the next Black Swan event. Our plans are stress-tested through events like the Great Recession, Dot-Com Bubble, and now, Coronavirus. If you want to understand how your portfolio might react to black swan events such as these, reach out to us. Call us at 913-393-1000 or schedule a complimentary consultation below and our relationship manager will reach out to you.

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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.