What is a Black Swan event?
As an investor, one is at the mercy of sudden events that lead to catastrophic losses of capital. An event that the market cannot predict and usually leads to negative consequences is called Black Swan. Nassim Nicholas Taleb popularized this term in a book titled Fooled by Randomness.
According to Taleb, Black Swan events have three distinguishing characteristics. First, they are impossibly difficult to predict because they are rare, and they strike when few expect. Secondly, Black Swans are severe in terms of the destruction they leave in their wake, and the consequences are often widespread. Thirdly, people will often rationalize a Black Swan event after its passing because of hindsight bias, meaning they convince themselves that the event could have been easily predicted.
The concept of Black Swans has its roots in the birds called Swans closely associated with ducks and geese. Swans are mostly white or grey, and hence the sighting of a Black Swan was always a rarity. Because the notion that all Swans were white was so strong, the appearance of a Black Swan must have shocked many. In this sense, the Black Swan theory argues that the unknown is more significant than the known.
The Black Swan theory has heavy usage in the world of finance. It is because most of the Black Swan events that have happened so far have had a massive impact on the global markets. We recall the top three Black Swans of the last decade, which tickled traders’ nerves in 2010 – 2020. Will the 2020 US election be the fourth and the last Black Swan in this decade?
On June 23, 2016, Britons went to the polls faced with a tough choice between remaining in the European Union and exiting. The decision to exit the EU took on the name ‘Brexit,’ a portmanteau of ‘Britain’ and ‘Exit.’ A similar referendum had been held in 1975, but the UK remained part of the European Economic Community (EEC) when the last vote was counted. Therefore, it was a huge surprise when news of the decision to exit the EU came out after the June 23 polls. 51.9% voted ‘Leave,’ and 48.1% voted ‘Remain.’
Why was Brexit a Black Swan?
The effect of the decision to leave the EU was instant. By July 04, the Sterling pound had declined by 11.5% against the US dollar to $1.2954 (see Figure 1). As the Europe – UK Trade uncertainty grew, in the next three months, the GBP fell by a further 5.6% to touch $1.2234, a level last seen 31 years ago.
Around the period when the sound of the Brexit chatter was increasing, equity markets began taking a beating. For example, the FTSE 100 lost 249.7 points between May 21 and June 11, 2016. Overall, Brexit left global markets with a $2 trillion hole in its wake. Because of the Brexit vote, the S&P 500 descended into a 9-day selloff that saw the index lose 5.6% of its value.
The trading opportunity during Brexit
In another sense, Black Swans are short-term crises that offer long-term trading opportunities. Often, a long recovery period follows the crisis, meaning investors have a huge opportunity to take long positions in the market. Even the fallout that follows a Black Swan event itself is a trading opportunity for the bears.
Because of Brexit, two trading opportunities emerged. The first one was an opportunity to short the British pound (GBP) in early June. It was almost certain that the selling pressure would mount against the GBP until the polls’ conclusion. A leave decision would convince more traders to sell, and this is what happened.
Secondly, there was a stock buying opportunity after the selling pressure in the capital markets started to wane. For the GBP, the selloff took longer to conclude because it was not until March 06, 2017, that the market turned bullish. Bearish pressure in futures eventually became a buying opportunity. As many tech companies were not affected by the Brexit Vote – many were sold off due to presence in major indexes. The decline in S&P500, Nasdaq lasted for two-three days. Afterward, the indexes kept rising after the Brexit vote.
Next, after the Brexit vote was the divorce, formally, Brexit was to happen on March 29, 2019, but disagreements on a proper deal pushed the divorce to January 31, 2020. In between the two dates, a series of developments fluctuated the global capital markets, but the UK market saw the most significant effect. These fluctuations presented great trading opportunities.
Shares rallied and declined almost in sync with certainty about the possibility of a Brexit deal. The FTSE rallied to a historic high of 7,778.79 points in the runup to the first divorce date on May 12, 2018. Looking at the FTSE 100 rally since the day of the Brexit polls, this was an 18.26% growth in share performance.
Trump Election victory
What happened, and why was the Trump victory a Black Swan?
Donald Trump overcame the Clinton machine to clinch the US Presidency in November 2016. There was an explicit consensus among pollsters that Clinton would cruise to the White House with a wide margin, but that never happened. For this reason, some media establishments termed Trump as “The Black Swan President.”
In American politics, most candidates that end up winning the presidency have polls and odds on their side. For Trump, even his party seemed divided about his suitability, and experts saw Clinton as the President-elect in waiting. Besides being unexpected, Trump’s presidency has carried enormous consequences in racial upheavals and some significant capital market fluctuations. Additionally, a lot of ex-post rationalization of the November 2016 events has happened. No doubt, the Trump victory was a Black Swan.
Trading opportunities after the Trump victory
The market was jittery before the election on November 8, 2016. The VIX also called the fear index, jumped 28% to 17.06 in early October amid a scandal-struck Hillary Clinton, who was supposed to win the race. In the lead up to the November polls, Mrs. Clinton’s use of a private email server for official communications had become a hot potato, and Trump made good use of it. The email scandal was a clear and present danger to Clinton’s White House bid to some players in the market.
Simultaneously, the market descended into a selloff, though it was slight and short-lived. Nonetheless, this was the market signaling that things were not good. Between September 30 and the election eve, the S&P 500 shaved off 83.09 points.
But once the index bottomed, a great trading opportunity availed itself. Since Donald Trump’s election, the market has recovered fast, and it has touched historic highs twice and just six months apart. First, the S&P 500 peaked at 3,380.16 points on February 14, 2020, just before the COVID-19 pandemic consequences began to manifest. After government intervention, the market recovered fast to touch 3,580.84 points on September 02, 2020, a fresh historic high. Therefore, anyone who took a long position after the Trump victory earned more than 12% in annualized returns. The technology sector became the best performing under Trump presidency, despite the criticism of Big Tech.
The pandemic is a classic example of a Black Swan. It began as an unknown respiratory condition with pneumonia-like symptoms in Wuhan, China, in early January 2020 and later spread across the world like wildfire in California during summer. By January 20, four people had died in China from the disease that was yet to be identified. Cases of patients suffering from a similar disease appeared in Europe and the United States by the week ending January 24. By mid-February, COVID-19 was fast becoming a global pandemic.
A global selloff began around February 18 when most of the market was sure the pandemic was deadly. In 16 days, the S&P 500 had shed 29.5%. The S&P 500 took the shortest time – just 16 days – to reach a bearish territory during the pandemic than any other Black Swan event.
The trading opportunity
But as already argued and shown, markets eventually recover from sell-offs, no matter the size, and herein lies the trading opportunity. In this pandemic, tech stocks have offered the most lucrative trading opportunity, particularly the big six, namely Netflix, Microsoft, Apple, Amazon, Facebook, and Alphabet. All these companies recorded earnings growth in Q2 2020 compared to the same quarter last year.
Simultaneously, the year to date price returns for each of the tech companies’ stock is significant. By mid-August 2020, the YTD price returns were 52%, 31%, 68%, 24%, and 11% for Apple, Microsoft, Amazon, Facebook, and Alphabet. Comparatively, the YTD returns for the S&P 500 was 4.5% (including the tech giants).
Will the 2020 US election be a Black Swan?
The 2020 US election is shaping up into one of the most controversial in the country’s history. In the first place, the election is coming in the middle of a pandemic, meaning in-person voting could be hugely undermined. Mail-in voting seems like the most viable alternative, but the incumbent President thinks otherwise. As the elections draw closer, the President and his campaign machinery block attempt to expand mail-in voting across the country.
Without showing any evidence, the President claims that mail-in voting will lead to voter fraud. The Trump campaign has so far litigated against some states, including Iowa, New Jersey, Montana, and Nevada, connected with voting via mail.
Simultaneously, the Democratical Party shows no slowing down on biting the incumbent for every controversial speech, tweet, or decision. The main democratical candidate Joe Biden is endorsing any social anti-trump rhetoric. But wait… Where are the financial markets here?
Such uncertainty is never suitable for the silence-loving capital. With just about two months left until the polls, the US stock market and the USD are staring at a possible significant decline from historic highs recorded this year. However, the polls might not become a Black Swan because the market is already pricing chaos in November.
The Risk: In the stock market, “history always repeats itself,” right? Democrats’ rhetoric against the technological giants can cause even bigger FAANG selloff.
Similar to the 1911 Rockefeller’s Standard Oil break up, the Sherman Antitrust Act forced to split the biggest monopoly of that time into 34 spin-offs. The intention by democrats to split the biggest technology companies can add uncertainty in pre-election stock market season.
Black Swans are as destructive as they are beneficial. They disrupt the market in a way that creates trading opportunities both for the bears and the bulls. In the last decade, the Brexit, Donald Trump’s victory, and the COVID-19 pandemic yanked the market into troughs, but the recoveries have been massive. It means that investors should always remain alert to catch new trends when the market starts recovery. For instance, this year, the recovery period has seen the S&P 500 peak at record levels, and specific sectors like technology have outperformed the entire index.