When an event occurs that no one could have predicted nor saw coming that ends up having a significantly negative effect on the stock market, it is often referred to as a “Black Swan Event.” Such events almost always cause massive damage and leave the average investor in a state of fear and panic. The term was made popular by Nassim Taleb, who wrote about these events in his book, “Fooled by Randomness.” In it, he attributes three constant factors that must be maintained in a so-called “Black Swan Event.” They are:
- The event must be totally unpredictable.
- A Black Swan Event often results in severely negative results.
- After these events happen, people will rationalize it as having been totally predictable (hindsight-bias).
We can easily classify the COVID-19 pandemic as a Black Swan Event. No one, except possibly the Chinese, could have predicted the damage and the worldwide panic that the coronavirus was going to cause. Our stock market, as measured by the S&P 500 Index*, lost 38% in one month. According to the Bureau of Labor Statistics, America’s unemployment rate shot up to 14.7% in April while millions of people lost jobs due to government lockdowns. The American taxpayer went approximately $6 trillion deeper into debt as our government borrowed against future tax revenue through lending and monetary policy in an attempt to lessen the impact of the lockdowns. This, in fact, has turned out to be the quintessential definition of a “Black Swan Event.”
The stimulus-driven economy has driven the stock market to all time highs at valuation levels we have not seen since the dot com bubble. The Shiller P/E ratio, which is what many industry professionals use to determine if the overall markets are trading at reasonable levels, is currently (at this writing) trading at 33. Historically, this averages right around 16.7. This tells us that, relative to average market conditions, the market could be as much as 100% overvalued. We are either going to need a huge spike in economic growth, or we could likely see some type of significant correction.
When the valuation of the market is trading at such high levels, a slight shift in sentiment can lead to selling pressures. We are encouraging clients and investors, like we did last December, once more to review their current risk profile and take the risk levels in their portfolios to the lower part of their risk range. We are expecting to see significant volatility over the next 12 to 18 months. There seems to be a bevy of Black Swans circling our heads right now, and at any time they could be looking for a place to land. From Great Britain’s exit from the EU and stretched valuations, to unforeseen political and geo-political events, we see the risk in the market at its higher side. By no means are we saying to get completely out of the markets, because we know that over time, they are a great way to keep pace with inflation. Get in touch with your advisor, make sure you understand how much volatility you can stomach, and make sure that you are positioned accordingly.
We at MCM wish you and your family a very Happy New Year and an amazing 2021!