FYI | Oct 20 2015
By Peter Switzer, Switzer Super Report
If October is the month of bottoms, it’s also the month of crashes. The years 1929 and 1987 ring a bell and even the GFC got serious on November 1, which was so close to October that it’s not funny. So when ‘black swan’ talk intensifies, as it is right now, I can’t help but want to test it out.
In case you aren’t up with your swans, this is what Wikipedia says that a black swan in markets and economics is all about:
“The black swan theory or theory of black swan events is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight.”
The black swan could be China’s economic growth, the proliferation of quantitative easing around the world and the weaker-than-expected economic response or it could even be the impact of everything Middle East from ISIS, to Syria, to refugees and Russia getting involved militarily.
(I don’t think the Fed’s first small interest rate rise could derail the world, so I’m ruling this out of my black swan spotting exercise.)
For me, the economic response to QE and China look like the swans that could in all likelihood blacken up and shock a market or two.
The black swan test
Believe it or not but there is a black swan test called the CBOE Skew Index and it monitors options that are a long way out of the money for the S&P500. It’s when traders are backing the long shot of a big, scary sell off and the latest reading shows a 30% spike since September!
Last week, the index was at 148.92, which is higher than in 2006 before the GFC! Of course, this doesn’t mean that a GFC-style crash might happen but you can see why there is some negative excitement around a black swan event right now.
This level is even worse than when Long-Term Capital Management blew up in 1998 but what a lot of black swan experts leave out is that there have been lots of peaks where nothing happened. For example, look at the chart and see the 2014 breach of the green line when nothing happened. At best, the smarties in the markets, who price odd things like black swan events, have it at a 15% chance, which means the odds of a black swan no show is 85%. I prefer those odds but it doesn’t mean I’m right.
CNBC quoted chartist Chris Kimble of Kimble Charting Solutions, who thinks extreme readings for the index in recent years have become so numerous that you have to question how good its predictability is nowadays. I agree with Chris but you wouldn’t dismiss the index. No, you just treat it with caution.
“I would say the fears have been overblown and by no means is this smart money,” he wrote recently.
Moderate global expansion
And while there are those who are focused on the worst-case scenario for markets, I am more comfortable with the analysis from the team at Standard Life Investments with their quarterly Global Outlook research paper.
Jeremy Lawson, their chief economist sums it up neatly with:
“We continue to see a moderate global expansion into 2016, supporting modest corporate earnings growth outside the energy and materials sectors. Our view remains that a widespread or systemic emerging market financial crisis is unlikely, but the pressure on a number of large developing economies will not disappear quickly. Global GDP growth is expected to improve marginally but remain below trend,” he pointed out.
So he thinks the QE programs keep providing growth and for the doomsday dramatists, who see China as the black swan deliverer, Lawson is cautiously positive.
“At the epicentre of the crisis, in China, a hard landing is not our central scenario as we expect extra fiscal stimulus, but the transition to a new growth model will remain bumpy and unfriendly for commodity producers. More deceleration in growth could lie ahead and the Chinese currency is likely to weaken moderately against the dollar.’’
If Lawson was more negative on top of the Skew Index, I’d be more worried right now.
Muddle through
This is not the stuff of black swans but more like the “muddle through” thesis that I think explains most economic challenges and cycles.
Looking for even greater optimism or black swan crushers and I go to Bill Miller of LMM Investments in the US, who says moderate growth, low interest rates and low inflation has to be good for stocks. He actually has put this slow, grinding higher economic and stock market cycle into some intelligent perspective.
He’s more worried about everyone piling into stocks so this skepticism phase is really a good thing. “My concern is the stock market starts going up 20 or 30% a year like it did in the late 1990s. And then after two or three years, you can’t make money on anything. I’m much more worried about that than the fact that the stock market won’t go up.”
Scepticism phase
One of my briefs, and the one I do for all of my subscribers, is to watch the major economic drivers that could help or hurt stock prices and right now the balance of these is still towards us being cautiously positive.
I think Bill Miller had a brilliant take on what’s going on now, and as he manages over $US3 billion, you’d kind of expect some smart stuff from him.
He told CNBC that it took time for the conditions that created the 2008 GFC financial crisis to build up, and “generationally, it typically takes a while for people to forget about things”.
This is why I think we are in the scepticism phase and the optimistic and euphoric phases lie ahead. They might not last all that long but they will coincide with QE programs in Japan and Europe providing better than expected growth and maybe China surprising on the higher than expected side with growth and/or another big stimulus program.
Goodbye October
My chartist buddies still hold optimistic views on where stocks go and I love Citibank’s call of 6,200 by the end of 2016 but as I have argued before, if it takes two years then we still make 18% in two years plus dividends and franking credits. I’d be happy with that but when this happens I’d have my binoculars out looking for the more likely appearance of a damn black swan!
That said I do look forward to waving October goodbye.
Peter Switzer is the founder and publisher of the Switzer Super Report, a newsletter and website that offers advice, information and education to help you grow your DIY super.
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