Beware of the black swan. Black swan events were introduced by Nassim Nicholas Taleb in his 2001 book Fooled By Randomness, which concerned financial events. His 2007 book The Black Swan extended the metaphor to events outside of financial markets. Taleb regards almost all major scientific discoveries, historical events, and artistic accomplishments as “black swans”—undirected and unpredicted. He gives the rise of the Internet, the personal computer, World War I, dissolution of the Soviet Union, and the September 2001 attacks as examples of black swan events.
My top Black Swan events for 2014 and how to recognize them early and successfully survive them if not outright profit from them.
1. Market crash– early warning signs are large swings up and down, dramatic pick up in volatility. Think summer of 1987, tech bubble of 2000 and oil price gyrations in 2008 all augured for big price moves. Buy S&P put options as far out as you can. No telling when this will happen so buy yourselves as much time as you can get. At the moment too many people talking of market crash so this is a low probability event. Don’t waste too much money on these far out index puts.
2. Collapse in social media and related Internet plays– early warning signs are parabolic launch in price 50-100% moves in one trading day, not six months. Try deep in the money puts a couple of year out on social media stocks. But wait for a crack before you strike, then move quick. Many of these stocks are impossible to short and the premium on the puts is nauseatingly rich. It won’t matter though. When the emperor’s clothes come off, the entire sector will crash. Most of the newly launched Internet companies have the same business model, advertising. They are so many hours in the day and the advertising budgets can only rise in line with population growth over the long-term. The pie’s not growing fast enough to keep all the billionaire boy’s clubs full. Buy deep in the money puts as far out as you can and forget about them. The most money I ever lost was shorting two Internet stocks in 1999 that eventually were to bankrupt. As they say, the market can be irrational far longer than you can be solvent. Puts are one way to limit your pain and maximize your gain. This one is a matter of when not if.
3. China banking meltdown– Soros’s newest thing to fret about. China’s state-owned banks reported healthy profit growth in the third quarter, but big increases in loan impairments and decreases in their cushions to absorb losses pointed to accumulating stresses in the country’s financial system. A $6.6 trillion credit binge during the past five years, encouraged by Beijing policy makers as stimulus to combat a global economic slowdown, now threatens to stoke a debt crisis. At stake are trillions of yuan in bank loans that companies producing everything from ships to steel to solar power are struggling to repay as the world’s second-largest economy heads for the weakest annual expansion since 1999. According to a Bloomberg article, China’s total credit will be pushed to almost 250 percent of gross domestic product by then, almost double the 130 percent of 2008, according to Fitch.The nation might face credit losses of as much as $3 trillion as defaults ensue from the expansion of the past four years, particularly by non-bank lenders such as trusts, exceeding that seen prior to other credit crises, Goldman Sachs Group Inc. estimated in August. Short banks, ship builders, solar panel manufacturers, and steel and cement manufacturers. If it turns into a full blow meltdown, S&P 500 stocks are sure to follow as much of the growth in multinational revenue in recent years has been from the burgeoning Chinese consumer group.
4. Israeli preemptive strike on the nuclear reactor installations in Iran will trigger a run on stocks. Saudi American ambassador to the UK recently published an editorial that was tantamount to a call to arms. Don’t expect Israel with memories of the Holocaust embedded in the DNA of every citizen to sit idly by. Politics and war make strange bedfellows. Saudis’ will fund the Israelis and provide the close logistical support that Obama may be withholding. As Obama’s term gets closer to being a lame duck end, expect the Republicans raise the heat on the Iran peace talks encouraged by the lobbying efforts of the powerful AIPAC lobby. Oil skyrockets in price and defense stocks rally. Everything else goes down except safe haven Treasuries and U.S Dollar.
5. Sino Japanese War– this is the scariest of all the black swans. Tensions between China and Japan have racketed up to levels not seen since the WWII brutal invasion. The enmity many Chinese hold for Japan was palpable during my recent trip to China. There is an entire floor in the Hong Kong Museum of History devoted to the Japanese occupation. While we were in Shanghai the Chinese military scrambled jets to fly over the newly expanded Chinese air defense zones. This could be really a bad one and probably the most dangerous of all black swans. Buy way out of the money puts and bet everything. The market is sure to crash if the world’s second and third largest economies start duking it out.
6. Korean peninsula accident– self contained nuclear detonation. The whack job running the North just executed the number 2 there in a public hanging. So happens it was his uncle. This ruthless pathologic deranged and inbred leader is sure to self detonate. I think this can be contained with just a 20% sharp but quick market correction. It should be over in 3 months unless the Chinese get involved and it turns into thermonuclear WWW III.
7. Strong market rally. Market has back to back 30% up years with no real earnings growth. Hey, black swans can be good things t0o. This is not as far flung as the masses of baby-boomer babies, the “whatever” generation is bound to start feeding themselves in masse. The sheer momentum of this population shift will create huge economic activity even if it is replete with non stop texting and excessive video game playing.
Well, that’s it for now. I’m thinking about playing all of these things. Maybe it’s just a straddle. Buy long- dated deep out of the money calls and puts and find a good book or two, that is iPad, and escape to some island likely not to receive nuclear fallout or Chinese pollution in 2014. Seriously folks, if you have any Black Swan ideas, please comment on them below. I’m all out.