“A leader has the right to be beaten, but never the right to be surprised” – Napoleon Bonaparte.
If we had been likely to encounter a ‘Black Swan’ in markets, this week offered up one of the more promising opportunities to date. On the back of a tripling of stamp duty (from a puny 0.1% to a still inconsequential 0.3%), Shanghai stocks – a market already up by over 60% this year - “plunged” by over 6% on Wednesday. Having incurred significant contagion drawdowns during a similar environment back in February, non-Chinese investors nervously awaited their own local markets’ response. It came in the form of a deafening yawn. One could conclude that many investors, ourselves included, had reacted to earlier evidence of obvious overvaluation in Chinese stocks by pre-emptively taking some China-sensitive risk (notably diversified mining and resource stocks) off the table, notwithstanding the fact that a hysterically overbought equity market and a fast-growing already significant economy are not one and the same thing. That the world did not come to an end obviously provided some relief. Cynics might also point to the coincidence of the post-China market bounce with the May month end (all those pesky fund managers). In any event, the S&P 500 reacted to Chinese market angst by reaching a new all-time high. If it was a Black Swan, it was not drowning, but waving.
We have Nassim Nicholas Taleb¹ to thank for the ‘Black Swan’ hypothesis. In essence, the existence of a thousand or even a million white swans does nothing to disprove the existence of a non-white swan. Spotting just one black swan is sufficient to do that. Absence of proof, in other words, is not the same as proof of absence. The black swan originally broke the surface six years ago². It is now back, along with concepts like Mediocristan (where the happy predictability of the Gaussian bell curve governs all) and Extremistan (where wildness, true unpredictability and Black Swans thrive).
Taleb highlights the difficulties we face with knowledge, not least our preference for the anecdotal over the empirical. For ‘empirical’, read: developed by observation and experiment, rather than by deduction from general principles. “Deduction from general principles” sounds suspiciously similar to “heuristics”, the process of seeking shortcuts to answer the questions thrown at us by the financial world that behaviouralists tell us often ends in disaster. The OED gives two contradictory definitions for anecdotes: secret, private, hitherto unpublished narratives; and narratives of a detached incident or single event, told as being in itself interesting or striking. (“Global financial system resilient in face of fall,” was how the FT greeted Thursday’s market recovery, “Investors retain their appetite for risk”. Well, for the moment, Lord Copper.)
One of the biggest problems in a worldwide web-enabled financial environment is keeping one’s head above the torrent of garbage masquerading as information. As John Naisbitt once said, we are drowning in information and starved for knowledge. Since technology has not managed to compress more hours into our day, we are forced to compromise in our intake of data. Rather than attempt to sip selectively from a fire hydrant, we inevitably defer to consolidators and aggregators – the financial media – in at least some of our consumption of supposedly relevant “news”. Handing over our editorial filter to others can lead to some awkward tensions between a complex world and somebody else’s interpretation of reality. Last week on Bloomberg’s “TOP” screen, for example, the following headlines appeared simultaneously:
“5) Looming Crash Prompts Most Hires for Distressed-Debt Traders Since 2002
7) Junk Bond Risk Premiums Fall to a Record Low on Signs Economy
The world is evidently more complex and nuanced than many financial journalists (or headline writers) feel it is – a point which Taleb would surely accept. But Taleb’s response would strike most readers as extraordinarily ascetic: “I.. completely gave up reading newspapers and watching television, which freed up a considerable amount of time (say one hour or more a day, enough time to read more than a hundred additional books per year, which, after a couple of decades, starts mounting). But this argument was not quite the entire reason for my dictum in this book to avoid the newspapers, as we will see further benefits in avoiding the toxicity of information. It was initially a great excuse to avoid keeping up with the minutiae of business, a perfect alibi since I found nothing interesting about the details of the business world – inelegant, dull, pompous, greedy, unintellectual, selfish, and boring.”
Some other aspects of the Black Swan problem ? Confirmation error: our tendency to ignore those bits of information that might challenge one of our pet theories. Taleb has a wonderful way of tackling this – he refers to the concept of an “Antilibrary”, where read books are far less valuable than unread ones. In markets, what we don’t know is absolutely more dangerous than what we do. Narrative fallacy: human beings are suckers for stories and anecdotes, over what is likely to be an altogether messier and more complicated reality. And the problem of silent evidence: an atheist in ancient times was shown painted tablets showing the portraits of worshippers who prayed and then had the good fortune to survive a subsequent shipwreck. His response: where are the pictures of those who prayed, then drowned ? Again, absence of proof..
Taleb makes a particularly forceful case when it comes to misguided belief in the validity of the Gaussian (normal distribution) bell curve. Pseudo-scientists in financial markets believe they inhabit Mediocristan, a territory where extraordinary events never occur, and variation clusters uniformly around the mean. Fund managers and traders who aspire to a long career would do better by acknowledging Extremistan. It was Extremistan, for example, that suffered the market crash of 1987 – and the subsequent recovery. It was Extremistan (and hedge fund LTCM, and the global financial system) that suffered the Russian default and global credit market freeze of 1998. It was Extremistan that suffered September 11, 2001. The next “unanticipated” 27 standard deviation event will not occur in a hypothetical region called Extremistan, but here on planet Earth.
As Taleb writes, after defaults in Southern and Central America, “In the summer of 1982, large American banks lost close to all their past earnings (cumulatively), about everything they ever made in the history of American banking – everything.” It is not given to us to know the precise nature of the next market crisis – it wouldn’t be a Black Swan otherwise. For all the guff widely spouted about overvalued equities, Black Swan spotters would be advised to look elsewhere – over-extended credit markets might be a good place to start.
¹‘The Black Swan: the impact of the highly improbable’ (Allen Lane, 2007)
²‘Fooled by Randomness: the hidden role of chance in the markets and life’ (Texere, 2001)