Kass: Black Swans Return

This blog post originally appeared on RealMoney Silver on June 14 at 8:00 a.m. EDT.

Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words, it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks -- when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crises less likely, but when they happen, they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur ... I shiver at the thought.

Banks hire dull people and train them to be even more dull. If they look conservative, it's only because their loans go bust on rare, very rare occasions. But ... bankers are not conservative at all. They are just phenomenally skilled at self-deception by burying the possibility of a large, devastating loss under the rug.

The government-sponsored institution Fannie Mae (FNM), when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deemed these events "unlikely."

There is no way to gauge the effectiveness of their lending activity by observing it over a day, a week, a month, or ... even a century!

[T]he real-estate collapse of the early 1990s ... required a taxpayer-funded bailout of more than half a trillion dollars. The Federal Reserve bank protected them at our expense: when "conservative" bankers make profits, they get the benefits; when they are hurt, we pay the costs.

Once again, recall the story of banks hiding explosive risks in their portfolios. It is not a good idea to trust corporations with matters such as rare events because the performance of these executives is not observable on a short-term basis, and they will game the system by showing good performance so they can get their yearly bonus. The Achilles' heel of capitalism is that if you make corporations compete, it is sometimes the one that is most exposed to the negative Black Swan that will appear to be the most fit for survival.

As if we did not have enough problems, banks are now more vulnerable to the Black Swan and the ludic fallacy than ever before with "scientists" among their staff taking care of exposures. The giant firm J. P. Morgan (JPM) put the entire world at risk by introducing in the nineties RiskMetrics, a phony method aiming at managing people's risks, causing the generalized use of the ludic fallacy, and bringing Dr. Johns into power in place of the skeptical Fat Tonys. (A related method called "Value-at-Risk," which relies on the quantitative measurement of risk, has been spreading.)

Please, don't drive a school bus blindfolded.

Owing to ... a misunderstanding of the causal chains between policy and actions, we can easily trigger Black Swans, thanks to aggressive ignorance -- like a child playing with a chemistry kit.

-- Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable

The new normal is abnormal and is bound to haunt investors for some time to come.

I am not referring to Pimco's Mohamed El-Erian's notion that world economic growth will be lower. I am referring to the new normal of disproportionate, high-impact, hard-to-predict rare events beyond the realm of "normal expectations in business, history, science and technology" that are occurring with startling frequency. (As Dr. Benoit Mandelbrot emphasized in his work, the distributions of systemic outcomes aren't normal/Gaussian, but rather fat-tailed.)

Risks of black swans, previously perceived to be small by corporations, investors, politicians and regulators, are now being reassessed, owing to (among other issues) globalization, tighter correlations, advancements in technology, the growing/excessive complexities of interlocking supply chains and derivatives, the acceptance of greater/extreme risk-taking ("the longer people make money by taking risk, the more imprudent they become," the Minsky moment), the greater connectivity of increasingly more complex systems (see Paul Ormerod and Rich Colbaugh) and so forth.

A greater and more dynamic instability is the new normal. Witness some of these historical black swan events over the past decade:

• the September 11 attack on the World Trade Center;
• financial derivatives roil the world's banking system and financial markets;
• the failure of Lehman Brothers and the sale/liquidation of Bear Stearns;
• BP's (BP) Gulf oil spill; and
• the market's flash crash (a 1,000-point drop in the DJIA on May 6, 2010).

Once a year, I produce a surprise list to introduce my own mini black swans. These are investment and business events that are outliers. I call them "probable improbables."

We can no longer turn the clock back to a simpler time. We must play the hand we are dealt.

For years, investors have been blinded to the uncertainty and unaware of the broad effect of the rare, black swan event, but we now know that these black swans (which seem to be occurring with greater regularity) are not only growth-deflating but, more importantly, are valuation-deflating.

The world is interconnected, interlinked and increasingly complex. It faces numerous structural issues (e.g., extreme fiscal imbalances at the federal, state and local levels), with governments (here and abroad) not necessarily up to the task of dealing with the complexities. Given the "newness" of these and other challenges as well as the greater frequency of black swan events, P/E multiples are being pressured and should continue to contract as a comparison between today's valuations to those of history can be expected to lose some of its significance and relevance.