Black: Swans and Crude (Sonders)

Black: Swans and Crude

by Liz Ann Son­ders
Seni­or Vice Pres­id­ent, Chief In­vest­ment Strategist, Charles Schwab & Co., Inc.

Key Points

• Eco­nom­ic/fin­an­cial "black swans" are gen­er­ally more dire than geo­pol­it­ic­al ones.
• The Middle East is today's hot­bed for po­ten­tial geo­pol­it­ic­al crises.
• Oil is tak­ing the brunt of the pres­sure, but it's not ne­ces­sar­ily the death knell for stocks or the eco­nom­ic re­cov­ery.

You can glance at any long-term chart of the stock mar­ket and point to spe­cif­ic events that pre­cip­it­ated many of the big ups and downs:

1. Ja­pan bombs Pearl Har­bor, Decem­ber 1941
2. Ja­pan sur­renders in WWII, Au­gust 1945
3. Cuban Mis­sile Crisis be­gins, Oc­to­ber 1962
4. Pres­id­ent Kennedy as­sas­sin­ated, Novem­ber 1963
5. Pres­id­ent Re­agan shot, March 1981
6. Chernobyl nuc­le­ar melt­down, April 1986
7. Op­er­a­tion Desert Storm be­gins, Janu­ary 1991
8. Septem­ber 11, 2001
9. Leh­man Broth­ers col­lapses, Septem­ber 2008
10. Stand­ard & Poor's down­grades US debt, Au­gust 2011

Stocks and Black Swans

Source: FactSet, as of Janu­ary 31, 2012.

These ex­amples rep­res­ent a mix of geo­pol­it­ic­al and eco­nom­ic/fin­an­cial "black swan" events or crises—ones that are both sur­pris­ing and have a ma­jor im­pact. Eco­nom­ic/fin­an­cial crises tend to have more severe and longer-last­ing im­plic­a­tions for both mar­kets and the eco­nomy. Half of the top 10 single-worst days in his­tory for the Dow Jones In­dus­tri­al Av­er­age oc­curred dur­ing the 2008 fin­an­cial crises. On the oth­er hand, geo­pol­it­ic­al crises tend to have a less­er and short­er-dur­a­tion im­pact.

Geo­pol­it­ic­al crises

Black swans of the geo­pol­it­ic­al vari­ety oc­cur more fre­quently than eco­nom­ic/fin­an­cial crises, with a less-severe im­pact gen­er­ally. On the first trad­ing day after the Cuban Mis­sile Crisis, the S&P 500® in­dex sank by nearly 4%, but only six months later the mar­ket was up nearly 25%. Over the one-month peri­od after Ir­aq in­vaded Kuwait (the move that even­tu­ally led to the first Gulf War), the S&P 500 fell nearly 10%, but one year later it was up more than 10%.

At times, the re­bounds have been slower. After the bomb­ing of Pearl Har­bor, the S&P 500 had a quick and severe drop and was still lower six months later. But by the time Ja­pan sur­rendered al­most four years later, the mar­ket had re­boun­ded by nearly 60%. Fast-for­ward to the 9/11 ter­ror­ist at­tacks. In­deed, the stock mar­ket was severely shaken between Septem­ber 10 and Septem­ber 21, 2001, with a drop in the S&P 500 of nearly 15%. But just two months later, the mar­ket had re­gained its pre-9/11 level.

Middle East hot­bed

Today we're reg­u­larly faced with heightened event risk due to polit­ic­al in­stabil­ity, not­ably in the Middle East. Last year, Peter Brookes, a seni­or fel­low for na­tion­al se­cur­ity af­fairs with the Her­it­age Found­a­tion, re­leased an over­view of the glob­al geo­pol­it­ic­al land­scape. He lis­ted the fol­low­ing as po­ten­tial causes of black swan events:

• Ir­an's nuc­le­ar/mis­sile pro­grams, sup­port for ter­ror­ist groups, and in­volve­ment in Le­ban­on, [Syr­ia], Ir­aq, Afgh­anistan and Middle East re­volts
• North Korea's nuc­le­ar/mis­sile pro­grams, nuc­le­ar pro­lif­er­a­tion, on­go­ing lead­er­ship trans­ition and acts of pro­voca­tion
• Over­all ter­ror­ist threats in­clud­ing Al Qaeda core, Al Qaeda in the Ar­a­bi­an Pen­in­sula and homegrown ter­ror and plots
• Venezuela's Bolivari­an Re­volu­tion, nuc­le­ar as­pir­a­tions, ties with Ir­an and ties with FARC
• Pakistan and Afgh­anistan: Al Qaeda, Taliban and Haqqani net­works, se­cur­ity of nuc­le­ar ar­sen­al and Pakistani ten­sions with In­dia
• Rus­sia's grand am­bi­tions, en­ergy prowess and Arc­tic mil­it­ary mod­ern­iz­a­tion
• China's rising power, eco­nom­ic prowess, polit­ic­al clout and mil­it­ary buildup

Oil prices on the rise…

Most of today's greatest geo­pol­it­ic­al risks lie with­in the Middle East and by ex­ten­sion have an out­sized im­pact on oil prices. There's no ques­tion oil prices have a mac­roe­co­nom­ic im­pact, but there's on­go­ing de­bate as to mag­nitude and trans­mis­sion. A 2011 re­port by Rasmussen and Roit­man showed that the cor­rel­a­tion between oil prices and gross do­mest­ic product is ac­tu­ally pos­it­ive in more than 80% of coun­tries; only in the United States and Ja­pan is it neg­at­ive. One of the con­trib­ut­ing factors to this pat­tern is that in 90% of coun­tries stud­ied, ex­ports tend to move in the same dir­ec­tion as oil prices.

In fact, much of the in­crease in en­ergy prices since their Oc­to­ber 2011 lows can be ex­plained by the re­sur­gence in the glob­al eco­nomy; to a less­er de­gree the in­crease de­rives from fear about sup­ply dis­rup­tions due to ten­sions in Ir­an and Syr­ia. And since late 2008, when the Fed­er­al Re­serve moved the fed funds rate to 0-0.25%, the stock mar­ket (a lead­ing eco­nom­ic in­dic­at­or) and oil prices have been pos­it­ively cor­rel­ated, as you can see be­low.

Stocks and Oil Highly Cor­rel­ated

Source: FactSet, as of Feb­ru­ary 24, 2012. Dot­ted line rep­res­ents date when Fed­er­al Re­serve moved tar­get rate to 0-0.25%.

…but not a re­cov­ery deal-break­er

At some point, a con­tin­ued surge would be a risk to the pos­it­ive mar­ket and eco­nom­ic out­look I've had for some time, but at this stage it's not a deal-break­er for the re­cov­ery. For one thing, in the past cen­tury, the real price of gas­ol­ine has spent al­most all its time between $2 and $4 (in cur­rent dol­lars), and we're with­in that range today.

Yes, oil price spikes pre­ceded the 1973, 1980, 1991, 2001 and 2007 re­ces­sions, but the spike in early 2011 did not lead to one, and I be­lieve the cur­rent spike will also be an ex­cep­tion. US con­sumers are now much bet­ter po­si­tioned to weath­er high­er en­ergy prices, with well-im­proved job growth and con­sumer con­fid­ence, cred­it growth pick­ing up, ag­gress­ive Fed stim­u­lus and re­cord-low nat­ur­al gas prices. Most im­port­ant is the fact that en­ergy price in­fla­tion last year was largely spurred by the second round of quant­it­at­ive eas­ing by the Fed (QE2), where­as today's driver is glob­al growth.

As well, in the United States, spend­ing on en­ergy over­all as a per­cent­age of dis­pos­able per­son­al in­come is less than 6% cur­rently, down from the 8% of the early 1980s.

En­ergy Ex­pendit­ures as Per­cent of In­come

Source: FactSet, as of Decem­ber 31, 2011.

We've also wit­nessed in the re­cent past how quickly spec­u­lat­ive ex­cess can drain out of the price of oil, es­pe­cially when trades be­come "one-sided." Ac­cord­ing to the latest Com­mit­ments of Traders re­port, as of Feb­ru­ary 21, large spec­u­lat­ors held a re­cord net long po­s­i­tion in gas­ol­ine fu­tures con­tracts and the highest net long po­s­i­tion in light sweet crude oil fu­tures con­tracts since last May.

The best cure for high prices is high prices

High prices make it prof­it­able to bring in­to pro­duc­tion more costly re­sources glob­ally and dis­trib­ute pro­duc­tion more broadly, while also win­now­ing de­mand. Wit­ness the suc­cess of US oil sands, shale hy­dro­car­bons and bio-fuels. The United States and/or the In­ter­na­tion­al En­ergy Agency may also tap the Stra­tegic Pet­ro­leum Re­serve if prices con­tin­ue their as­cent, which will help drive down prices.

Ul­ti­mately we don't know if there's a tip­ping point for oil and what might drive the price to that level. And back to where I star­ted this re­port, shocks of the geo­pol­it­ic­al vari­ety tend not to have long-last­ing im­plic­a­tions for either the mar­ket or the eco­nomy. In­vestors un­doubtedly feel last­ing anxi­ety about the most re­cent ma­jor set of crises, and I'm of­ten asked to opine on the likely next crisis. It cer­tainly could be centered in the Middle East and cause an­oth­er spike in oil. But we would cau­tion in­vestors not to get too cute about port­fo­lio po­s­i­tion­ing around such a pos­sib­il­ity.

If you're look­ing for a black swan sur­viv­al kit, it could in­clude many of the tried-and-true in­gredi­ents that gen­er­ally serve in­vestors well over time:

• Be di­ver­si­fied, es­pe­cially now that as­set-class cor­rel­a­tions have be­gun to re­cede to­ward nor­mal levels.
• If you like to be op­por­tun­ist­ic, keep some powder dry in highly li­quid in­vest­ments for both cash needs and some flex­ib­il­ity to take ad­vant­age of volat­il­ity.
• Con­sider more fre­quent re­bal­an­cing if volat­il­ity re­as­serts it­self, al­low­ing you to sell in­to strength and buy in­to weak­ness.
• Fo­cus on your long-term goals and not short-term mar­ket dips so you're less likely to fall prey to pan­ic selling (or buy­ing).
• Re­view your port­fo­lio and as­set al­loc­a­tion to con­firm your risk tol­er­ance matches your fin­an­cial goals.

Or, you can try to fore­cast the next black swan event and try to po­s­i­tion ac­cord­ingly. We wouldn't ad­vise that.

Im­port­ant Dis­clos­ures

Di­ver­si­fic­a­tion strategies do not as­sure a profit and do not pro­tect against losses in de­clin­ing mar­kets.

The in­form­a­tion provided here is for gen­er­al in­form­a­tion­al pur­poses only and should not be con­sidered an in­di­vidu­al­ized re­com­mend­a­tion or per­son­al­ized in­vest­ment ad­vice. The in­vest­ment strategies men­tioned here may not be suit­able for every­one. Each in­vestor needs to re­view an in­vest­ment strategy for his or her own par­tic­u­lar situ­ation be­fore mak­ing any in­vest­ment de­cision.

All ex­pres­sions of opin­ion are sub­ject to change without no­tice in re­ac­tion to shift­ing mar­ket con­di­tions. Data con­tained herein from third party pro­viders is ob­tained from what are con­sidered re­li­able sources. However, its ac­cur­acy, com­plete­ness or re­li­ab­il­ity can­not be guar­an­teed.

Ex­amples provided are for il­lus­trat­ive pur­poses only and not in­ten­ded to be re­flect­ive of res­ults you can ex­pect to achieve.