Kass: A Contagion of Black Swans

This blog post originally appeared on RealMoney Silver on March 14 at 8:24 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 ... But not to worry: their large staff of scientists deemed these events "unlikely."

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.

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 Taleb, The Black Swan: The Impact of the Highly Improbable
Black Swans are occurring with greater frequency.

Last week's historic earthquake in Japan contradicts the notion and appearance of stability and is yet another Black Swan in a series that has (time and time again) threatened the order over the last decade.

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 and 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.)
"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown."

-- Woody Allen
Risks of more and repeated Black Swans, previously perceived to be small by corporations, investors, politicians and regulators, should now be 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 (Minsky's moment: "the longer people make money by taking risk, the more imprudent they become"), the greater connectivity of increasingly more complex systems (see Paul Ormerod and Rich Colbaugh's " Cascades of Failure and Extinction in Evolving Complex Systems") and so forth. I see a greater and more dynamic instability is the new normal. Witness the increased regularity of economically, politically and socially altering Black Swan events over the past decade (Note: three of the eight deadliest natural disasters in the last century have occurred since 2004):
  • the Sept. 11, 2001, attacks on the World Trade Center and Pentagon;
  • a 75% decline in the Nasdaq;
  • the 2003 European heat wave (40,000 deaths);
  • the 2004 Tsunami in Sumatra, Indonesia (230,000 deaths);
  • the 2005 Kashmir, Pakistan, earthquake (80,000 deaths)
  • the 2008 Myanmar cyclone (140,000 deaths);
  • the 2008 Sichuan, China, earthquake ( 68,000 deaths);
  • financial derivatives roil the world's banking system and financial markets;
  • the failure of Lehman Brothers and the sale/liquidation of Bear Stearns;
  • a 30% drop in U.S. home prices;
  • the 2010 Port-Au-Prince, Haiti, earthquake (315,000 deaths);
  • the 2010 Russian heat wave (56,000 deaths);
  • BP's (BP) Gulf of Mexico oil spill;
  • the 2010 market flash crash (a 1,000-point drop in the DJIA);
  • the broadening scale of unrest in the Middle East; and
  • Thursday's earthquake and tsunami in Japan.
It is for this and other reasons that I produce an annual surprise list to introduce my own set of mini Black Swans. These are investment and business events that are outliers -- what I call "probable improbables."

"It is often said that 'is wise he who can see things coming.' Perhaps the wise one is the one who knows that he cannot see things far away."

--Nassim Taleb
We can no longer turn the clock back to a simpler time. We must play the hand we are dealt. And our time is interconnected, interlinked and increasingly complex. And our hand has, at its core, a rising number of outlier or Black Swan events.

I should emphasize that my observations on Black Swans in today's opening missive should be put into perspective. We shouldn't be overly paranoid nor should potential outlier events blind us to investment opportunity.

But we must be mindful!

Throughout history, there have been times when it has even been more profitable for investors "to bind together in the wrong direction than to be alone in the right one." The long-term direction of equities will likely always be "higher," and the crowd of optimists will invariably outperform the remnants of pessimists.

Nevertheless, for years, investors seem to have been blinded to the uncertainty of the "rare" Black Swan event. We now know that these Black Swans are occurring with greater regularity and with greater overall impact -- and, as such, we must recognize that the occurrences may not only hold the potential for reducing aggregate growth but that the uncertainty of these outlier events could conceivably cast a pall over stock valuations.

After all, the inability to predict Black Swan events implies a greater inability to predict the course of economic and market history -- whether it is a natural disaster, a surprising geopolitical event or an unexpected economic or credit outcome.

It is only obvious after the fact, as investors, in particular, seem to harbor a crippling dislike for the abstract (like Black Swans). Perhaps the problem with experts is that they do not know what they do not know.

For some time, investors have been, as Taleb writes "picking up pennies in front of a steamroller," exposing themselves to the high impact, rare event yet sleeping like babies, unaware of it.

But recent events might bring on some nightmares.

Of a more immediate practical consequence to this writer is that our domestic economy faces numerous structural issues (the most important of which are the 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 nontraditional and secular challenges as well as the greater frequency of Black Swan events, P/E multiples might be pressured and could even contract as a comparison between today's valuations to those of history can be expected to lose some of its significance and relevance.
"If you hear a 'prominent' economist using the word 'equilibrium' or 'normal distribution,' do not argue with him; just ignore him, or try to put a rat down his shirt."

-- Nassim Taleb
In summary, I marvel at the confidence of strategists in a smooth and self-sustaining economic recovery in such an uncertain world.

Strategists routinely make valuation comparisons based on it rhyming with historical experience. Similar to the belief in bell curves, these compares should be viewed with caution, because, in all likelihood, another Black Swan could appear on our investment doorstep -- maybe sooner rather than later!

It truly is different this time.

In this setting, a more conservative asset mix and higher cash position than normal seems to be a prudent strategy.

After all, as Nassim Taleb wrote, we might all be Black Swans.

Doug Kass writes daily for RealMoney Silver , a premium bundle service from TheStreet.com. For a free trial to RealMoney Silver and exclusive access to Mr. Kass's daily trading diary, please click here.

At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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