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Black Swans, Falling Knives, and Market Corrections
(Note: companies that
could be impacted by the content of this article are listed at the base of the
story [desktop version]. This article uses third-party references to provide a
bullish, bearish, and balanced point of view; sources are listed after the
Balanced section.)
The word “correction” has been used more than usual on CNBC and other business news programs this week. At first, it seemed to make sense; after all, on Monday, the S&P 500 dropped by 3.4%. Then on Tuesday, it shed another 3.03%. By the market close on Tuesday, the broad index was down a total of 7.6% from its all-time high – the all-time high was less than a week earlier!
After a 28.9% run-up in value through 2019, then occasional pauses for significant events such as the exchange of fire between the U.S. and Iran, we continued to experience equities breaking new ground as buyers’ optimism remained high. A quick Google search uncovers stories from most major outlets that report on the stock markets wrote an article warning of the “The Next Correction” or “How to Recognize a Correction” over the last six months. Ignoring these warnings, the market continued to trade higher.
The trend toward higher levels seems to have finally been derailed. But, the word “correction” as it has been used historically, may not fit the dramatic shift in direction the past few days. The market move is much more likely to fall in the category of a “black swan event.” The distinction is worth understanding in that the reasons for the decline in market prices are different. It’s important to understand the nuances as the recovery from each is different.
Black
Swan
Among waterbirds, black swans are known to be erratic and nomadic. The term “black swan event” was adopted by the business world to refer to events that are extremely rare and produce a dramatic impact. The occurrences generally fall into the unforeseen category. Investors with an eye toward risk, manage assets with the knowledge that black swan events cannot be forecast. Although with almost every black swan event there are people who say they saw it coming, or in hindsight, try to figure out how to forecast the next time the same situation will happen, in most cases, the events are “one-offs” that are a combination of factors that will never occur again.
An Example of an event that helps define this category is the meltdown of the hedge fund Long-Term Capital Management (LTCM) in 1998. This black swan event almost brought the global financial system with it. Others include the dot-com bubble of 2001 and the financial crisis of 2008. These are pure examples in that they were sudden and unforeseen as to timing and impact. Another example used quite often is the attacks on the U.S. on Tuesday, September 11, 2001. Both the NYSE and the Nasdaq did not even open that day and stayed closed until Monday, September 17th. This was the longest shutdown of the exchanges since 1933. On the reopening of the NYSE, the DOW fell 7.1% setting a record for the largest one-day loss in history. By Friday of that week, it had declined by 14%. The unforeseen circumstance erased $1.4 trillion in stock U.S. stock market value in five trading days.
Stock market recoveries from black swan events are as different and uncertain as to the events themselves. The sell-offs are not part of the regular market “price-discovery” push and pull. The quick reaction to the uncertainty of a new situation is typically severe. Then, once enough light is shed on the “new” situation allowing the market to evaluate the possibilities, it typically acts “rationally.” One month after September 11, 2001, the S&P, Nasdaq, and Dow had recouped all of their losses — A 16.28% increase within 30 days.
Correction
The term “correction” is a market term for sell-off as a reaction to excess. Although most market participants don’t enjoy corrections, they are considered healthy. They are painful yet beneficial, not unlike a brush fire that prevents a wildfire, or the diet that one goes on after eating too much during the holidays, or even the paying down of charge cards after returning from an elaborate vacation. A stock market correction serves to pair the lofty gains accumulated in stocks from greed or speculation that got a bit ahead of itself. Without occasional sell-offs that become corrections, the market would be at a higher risk of a larger crash.
Corrections are often predicted by technical or fundamental market analysts. Using either of these analytical methods, predictions of turning points, and too much market strength are made. A common definition of a market correction is a decline of 10% or more in price movement. This decline is seldom all at once, so market participants have time to evaluate whether they think the market is in a correction stage. There’s a warning. As it declines, some will take money out, while others will view it as an opportunity to buy at lower prices. If the sellers exceed the buyers, prices generally decline until that imbalance reverses. If the market is down 10% or more, it is then that the writers of history will “officially” label the period a correction.
The
Difference Between a Black Swan Event and Correction is Important
Black Swan events are not corrections. If a forest has a brush fire that burns off leaves and twigs, thereby reducing the “fuel” that could lead to a devastating blaze, then the fire lowers the risk of an uncontrollable fire. Brush fires are expected and are somewhat cyclical. The brush fire is not unlike a market correction. If the same forest is unexpectedly in the path of lava from a volcano which suddenly erupts, that is similar to a black swan event. Unexpected events have unexpected length and duration.
COVID-19 (coronavirus) and its impact on stocks is not part of the normal market cycle. It was not foreseen and has had a sudden and large impact on market direction. This fits the definition of a black swan event. With the market reaching higher highs the previous year, there were many who were calling for a correction. This may be why so many are currently referring to what has happened in the past couple of days as a correction.
Recovery from a correction is not predictable, but far more predictable than a recovering from a black swan event. After September 11, the markets were closed for six days, and no one had any idea at what price level they would open or trade when they did. This type of event had never happened before so there was no history to assess and project the future. The COVID-19 event can be likened to Sept. 11 in that it has very little similarity to anything that has happened before.
The virus has severely impacted the Chinese level of economic activity, yet we don’t have a good read on what is really happening there. We don’t know if it will continue to spread if a cure for the sick or a preventative will be found effective, we don’t know if it will fade as viruses before it have or mutate into something deadlier. There is not enough information for the market to feel comfortable enough to make a forecast with enough conviction to act. Once some answers are found, early buyers are likely to set the tone for higher prices.
Falling Knives
Until there is more clarity, there is not likely to be a large retracing of market losses. There is a Wall St. axiom, which says, “don’t try to catch a falling knife.” This warns against buying when the market has significant downward momentum. The chance of your catching it just right is low compared to the chance of your getting hurt. It’s too dangerous.
Like most Wall Street axioms, there is an equal and opposite axiom. This, presumably, is what makes markets. The alternative advice suggests, “buy low sell high.” In real terms, if you liked the S&P last Thursday as it was breaking new highs, you should love it today while it’s 7.6% cheaper.
Investors of safe-haven stocks such as those tied to the price of gold and other precious metals have historically done well during shocks to the other markets. Many investment advisors aim to reduce risk by diversifying their client portfolios. Part of this protection involves allocating a percent of the portfolio to invest in gold and gold mining companies. Gold soared following September 11. On Monday of this week, the price of gold surged to its highest level since February 2013. It’s easy to see how stocks uncorrelated to the broader markets belong in portfolios that seek to protect themselves from unforeseen shocks.
Applicable to the current black swan event, another, albeit lesser-known bit of Wall Street wisdom was once uttered by Wall Street icon Art Cashin. He said, “Never bet on the end of the world. It only happens once.”
Suggested
Reading:
Containing Coronavirus has Caused an
“Oil Demand Shock”
Is the Market Disregarding Earnings
Results?
The Economic Symptoms from Epidemics
Have Been Felt Before
Sources:
Everyone seems to be
bullish on the stock market right now. Here’s what could go wrong
Wikipedia Black Swan (Cygnus
atratus)
Long-Term Capital Management (LTCM)
