Black: Swans and Crude
by Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
- 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.
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.
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.