Black Swans do not seem like something we have to worry about, but they are incredibly dangerous, especially when there is a whole flock of them.
North Korea’s threat of war, Spain’s treatment of Catalonia, and its potential wider effects on the European Union, risk of whether or not key legislation is going to get passed, and Trump’s legal issues are all separate low probability events that when coupled represent significant overall risk to the markets.
Black swans are extremely rare events. But just because the probability of any specific black swan event occurring is low, does not mean that the probability of some black swan event occurring is low.
What we really want to know is the probability of at least one of these events occurring. Mathematically, the probability of at least one event, P(at least one), equals 1 – P(none). As we include more possible black swans, that second term gets smaller and smaller, and the probability of at least one black swan event occurring goes up.
We can get very specific by making some assumptions. Suppose that we have four different once in ten year events that would be bad for the market. It may seem like we do not have to worry about them very much for a while, but the probability of at least one of those events occurring in the next year is 33%.
But what makes the situation worse is that the market bubble (yes; stocks really are overvalued, even though the market can still go higher) is built on so much interconnected risk. I have written about some of this before. For instance, a lot of the increase in the the S&P 500 and other indices are due to rising profits in the banking industry, and bank profits are largely dependent on the market going higher.
The influx of money into index funds like SPY have boosted more than just the sectors that are seeing growth, since you purchase all stocks in the S&P 500 index when you purchase SPY. This drives much of the market higher.
Another issue is that a lot of buying has been on margin. Every dip people are buying up stocks, and a lot of that purchase is debt based. This analysis of margin debt, while admitting that the peaks and troughs are not enough to use as a forward indicator, show high levels of margin debt when compared to historical levels. A sharp drop in the S&P 500 and other stocks would result in a sell off as margin calls are initiated.
But that is not the only debt that his propping up this bubble. The most November 2017 consumer credit report puts September’s provisional outstanding credit growth rate at 6.6% p.a. Total outstanding consumer credit is now $3.79T and it continues to grow at a rate far faster than the rate of inflation. That means that a lot of this recovery is dependent on debt, and it means that reduction in ability to pay debts would have a significant impact on bank profits, which again are largely responsible for market gains.
Finally, XIV may be indirectly driving the market higher, or at least preventing it from dropping. The buy the dip extends to XIV because it has done so well as a profit making system. That in turn suppresses the VIX which bolsters the S&P 500. While it is unlikely, a large drop in XIV could result in it being shut down, and at that point, VIX would see a massive spike and the floor would fall out from under the S&P 500.
While the odds of any specific black swan event occurring is low, the more types of black swans there are flying around out there, and right now we have a lot, the more likely it is that at least one of these events will be triggered. Maybe North Korea will follow through on its threats. Maybe the Catalonian crisis will get out of hand. Perhaps tax reform will fail. Or maybe we will see legal action brought against Trump. Or perhaps something completely different will trigger a major stock sell off. Do not assume that just because a single event occurs with very low frequency that some major event is not right around the corner. Furthermore, we need to recognize that a major sell off can be far more devastating due to the increased systemic risk generated by ETFs, the co-dependence between the markets and the banking industry, and the recent way in which people are trading volatility as a real asset class. While none of these conditions implies that a meltdown is imminent, they do increase the probability of one occurring and increase the probability of it being extremely severe.