TRADING INSIDER: Understanding ‘Black Swan’ Events, And How One Could Be Hiding In Plain Sight Right Now

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Global Stock markets have risen very strongly since their lows in March 2009.

In the US the S&P 500 is up close to 200% from its lows while the ASX has had a still solid but more modest gain of around 80%.

The difference in the performance of these two markets and also between the ASX 200 and the Nikkei (since Prime Minister Shinzo Abe and the Bank of Japan have actively been seeking to reflate the economy by promoting inflation) highlight that the primary driver of global stock market gains since the depths of GFC despair have not been economic fundamentals but central banks’ unconventional monetary policy actions.

Once rates hit zero, or near enough to it, in the US and UK the Fed and Bank of England both embarked on quantitative easing. That is they created money through the purchase of bonds from the market. Hitherto the money they used to purchase these bonds didn’t actually exist so the impact was that the Fed, which has been the primary driver of the rise in US stocks, expanded its balance sheet by buying these assets and issuing cash to the market.

The point of the exercise was to drop money onto the market in the hope that this would ignite “animal spirits”, both to increase risk taking at a market level but also to stabilise confidence in the real economy – on Main Street – so that economic activity would stabilise and then start to grow once more.

RBA Governor Glenn Stevens recently neatly summarised how QE works and the point of it at his annual speech to the Annika Foundation. Stevens said:

QE mainly works not by some credit multiplier mechanism, but by pushing down the cost of capital for the economy. Long-term rates fall below where they would otherwise be as the central bank bids for securities in the market. The former holders of those securities then have to redeploy the cash they now hold. Unless they are all content simply to absorb extra cash – unless, that is, the liquidity trap is fully in operation for all asset classes at all maturities – their efforts to acquire other assets with similar duration but somewhat higher risk will bring down yields on those other assets (including foreign assets), lowering risk premia and so on. This ‘search for yield’ means that financial conditions, broadly defined, ease: that is, the cost of capital to the non-financial sector declines.

It has been noted that this amounts to more risk-taking among investors. Indeed it does. While in some discussion it seems to be implied that this is a bad thing, actually prompting more risk-taking is the whole point. Assuming we accept the notion that there is a role for stabilisation policy, when appetite for risk evaporates its job is to respond in a way that helps to restore that appetite, up to a point.

It is a policy that has been spectacularly successful in slowly reigniting growth in the US, UK and Japan where the central banks have actively expanded their balance sheets through QE. European growth, where the ECB has not pursued QE, has been the major economic laggard and its economy is now slipping back into recession.

But the risk to this policy is that the performance of US stocks, the global bellwether, has become inextricably tied to the growth of the Fed’s balance sheet under QE.

QE is now in its third iteration so there are lessons that can be learned from the earlier period when the Fed stopped buying bonds when QE’s 1 and 2 end. At both times the market fell which – as much as the real economy – lead to the next round of QE in the latest case the much bigger QE3 which initially saw the Fed spend $85 billion a month buying bonds.

The market reacted accordingly, with the S&P rising steadily throughout QE3.

However the Fed has signalled that QE 3 will end in October and they will no longer be buying bonds and putting cash into the market. Equally while it is premature to start easing, they are giving guidance that rates will eventually need to normalise.

Based on the lessons of the end to QE1 and QE2 it could be that with the S&P 500 near all-time highs, the ASX 200 at post GFC highs and stock markets around the world similarly ebullient, that the end to the Fed’s quantitative easing is a significant risk event hiding in plain sight.

Indeed RBA Governor Stevens recently warned he thought the market backdrop would look very different once the Fed started raising rates while Former US Treasury Secretary (and former New York Fed President during the dark days of the GFC) Timothy Geithner warned “In lots of ways, markets’ pricing of risks is implausibly benign at the moment, but the risks are not comparable to what we faced before 2008”.

So why are traders so complacent around the world, why has volatility been so low and why is there effectively no real risk premium for assets which otherwise be offering higher returns and trading at much lower prices?

The RBA put it best in their Statement on Monetary Policy released in August when they said:

History suggests that the current low volatility environment will not persist indefinitely. When a shock eventually occurs that is sufficiently large to cause volatility to increase, investors that had responded to the earlier decline in volatility by increasing leverage or their exposure to riskier assets could face significant losses. The resulting unwinding of these positions in an environment where there are large numbers of investors seeking to exit the same positions increases the likelihood that some markets could become one-sided, thereby exacerbating the initial rise in volatility.

In layman’s terms investors and traders get lulled into a false sense of security, take bets that are too large or lazy, and then something happens to scare the pants off them and everyone runs for the same exit.

This is what might be called a “black swan” event. The term was coined by author Nassim Taleb to describe events that happen unexpectedly and have a large impact – by definition they come out of left field, are a shock and can’t be forecast.

They are the “unknown unknowns” in Donald Rumsfeld’s famous quote.

So by any classical understanding a black swan they can’t really hide in plain sight.

But as RBA Glenn Stevens recently said – markets might look very different once the Fed moves from reducing the amount of stimulus it is adding to actually tightening rates. Essentially traders and investors are ignoring reality until it hits them in the face.

That’s the risk facing investors in the next six months and it’s why legendary hedge fund manager George Soros is increasing the protection that his portfolio is carrying via put options in case the market falls.

The opinions expressed in this article are those of Greg McKenna and do not reflect the views of nabtrade.

More Trading Insider:

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Here’s Why Markets Should Be Wary At Times Of Low Volatility

Here’s Where To Find Out How Australians Are Spending Money, And Why It Can Help Your Investment Decisions

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