“If you hear a ‘prominent’ economist using the word ‘equilibrium,’ or ‘normal distribution,’ do not argue with him; just ignore him, or try to put a rat down his shirt.”
– Nassim Taleb, The Black Swan
Facing the Unexpected
For centuries, there existed a widespread belief in Europe that all swans were white. This conviction was firmly rooted in logic and backed by substantial evidence.
Every swan observed was white, leading to a seemingly irrefutable conclusion. It was an assumption built on solid evidence, rendering it a universal truth.
However, in the late 17th century, a Dutch explorer discovered black swans in Australia, shattering this long-held belief. This revelation highlighted the fragility of human knowledge and how swiftly assumptions can fall apart when confronted with the unexpected.
In his book The Black Swan, Nassim Taleb defines a Black Swan as an unforeseen event that takes everyone by surprise, resulting in profound, far-reaching consequences. After such events occur, people often convince themselves that it was predictable all along.
Black Swan events possess distinct characteristics. Firstly, they are unpredictable outliers—surprises that defy forecasting. Secondly, their impacts are monumental, capable of rewriting history and transforming our understanding of the world. Lastly, in retrospect, people construct narratives that make these events seem obvious, a phenomenon Taleb refers to as the “narrative fallacy”—our innate urge to simplify chaos through storytelling, even if it misleads.
History is replete with Black Swan events. Here are a few notable examples…
War of the Nerds
On June 28, 1914, Gavrilo Princip, a Bosnian Serb student, assassinated Archduke Franz Ferdinand of Austria in Sarajevo. At that time, Europe was a volatile powder keg. This single act unexpectedly ignited World War I.
The major powers in Europe believed their intricate military and economic alliances would prevent large-scale conflict. Instead, this assassination triggered a chain reaction leading to a war that was meant to be the war to end all wars. What began as an unpredictable catalyst soon escalated into chaos.
Surprisingly, this Black Swan event wasn’t recognized right away. Even three weeks after the assassination, financial markets were still dismissing the risks involved.
Frederick J. Sheehan authored an article titled War of the Nerds, which appeared in the December 2006 edition of Marc Faber’s Gloom, Boom & Doom Report. We preserved the following excerpt from Sheehan’s now-closed AuContrarian website:
“Every generation suffers its particular fantasies. A century ago was no different. Investors had grown so accustomed to ignoring the repercussions of war that bond markets from London to Vienna remained relatively unfazed following the assassination that instigated World War I.”
“Three weeks later, in the summer of 1914, the fear premium was just one basis point. In swift order, European markets ceased to function—remarkably, without a formal declaration of war, yet minds were racing.”
Indeed, the complacency surrounding risk can shift rapidly. The detachment between investors and potential calamity can vanish in an instant. As Sheehan noted, the financial markets transformed from full operation to complete paralysis despite no immediate shots being fired.
“Unthinking Attack on Reason”
In the late 1980s, the Soviet Union was perceived as a powerful, albeit struggling, superpower. Yet by the end of 1991, it had crumbled, dismantling the post-WWII bipolar world order.
The swiftness and the relatively peaceful nature of its collapse came as a startling shock, redefining geopolitics. In hindsight, we dissect the economic stagnation, central planning failures, and internal pressures that led to its unraveling.
However, few analysts accurately foresaw its imminent dissolution. Most assumed any change would be gradual or violent.
James Dale Davidson, co-author of the newsletter Strategic Investment, encountered ridicule for his predictions about the Soviet collapse. He was dismissed on the Today Show for supposedly reckless thinking, and Newsweek decried his outlook as “an unthinking attack on reason.”
Financial markets themselves are not immune to Black Swan events. On October 19, 1987, the Dow Jones Industrial Average plummeted by an unprecedented 22.6 percent in a single day—the largest one-day percentage decline in history.
This incident, known as “Black Monday,” was unexpected. While there were warnings of an asset bubble, few anticipated such a drastic and sudden market crash.
Experts rushed to provide explanations after the fact, attributing the decline to everything from program trading to investor panic. Yet, like Davidson’s forecasts, some investors had anticipated this turmoil. They might not have predicted the precise event, but their foresight provided them a way to leverage the situation.
Nassim Taleb profited substantially from Black Monday, netting around $35 to $40 million through strategic positions in out-of-the-money put options on Eurodollar futures. However, he wasn’t the only significant winner…
On Black Swans and White Lies
By the end of Black Monday, hedge fund manager Paul Tudor Jones had triumphed, tripling his fund’s value and earning an estimated $100 million—an extraordinary amount for that time. How did he achieve this?
Simply put, Jones took actions contrary to the majority of investors. Over the preceding five years, U.S. stocks had almost tripled in value. Most believed this upward trend would remain unbroken.
Nonetheless, Jones understood the irregularity of market cycles and anticipated a crash. He demonstrated the courage to significantly short the market. Consequently, when the Dow dropped 22 percent, he turned his investors’ money into a threefold return while pocketing $100 million for himself.
As individual investors, we can gain valuable insights from Taleb and Jones. Black Swan events may indeed be unpredictable, but the misconception is that they cannot be anticipated. They will occur. Preparation is key.
Furthermore, recognizing the irregular yet inevitable cycles of the economy and stock market allows us to allocate some of our assets to those that do not necessarily correlate with overall market trends.
This accessible strategy can help secure significant— asymmetric—gains during inevitable market downturns. Positioning assets to benefit from key turning points embodies the essence of the Prism Investing Framework.
At present, the stock market, represented by the S&P 500, is nearing an all-time high, with valuations at historic highs. Yet, bubbles can persist for extended periods. With recent monetary expansion (as indicated by the FOMC’s decision to lower the federal funds rate by 25 basis points), the bubble might continue to inflate.
It is crucial to acknowledge that the stock market’s ongoing ascension, due to monetary policies, will be nominal; in real, inflation-adjusted terms, stock values will likely decline as the dollar weakens against goods and precious metals.
Holding gold is essential in the current environment. Additionally, maintaining cash reserves to invest in undervalued assets after the impending market crash is a prudent strategy.
Whether it is comfortable or not, the reality remains: a Black Swan event is on the horizon. At the very least, you should prepare accordingly.
[Editor’s note: Subscribe to the Economic Prism mailing list to receive a complimentary copy of an essential report titled, “Utility Payment Wealth – Profit from Henry Ford’s Dream City Business Model.” For a special trial offer to explore MN Gordon’s Wealth Prism Letter, you can access that here.]
Sincerely,
MN Gordon
for Economic Prism
