"The straws were mounting on the camel's back even as dark clouds were gathering."-Barton Biggs
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Welcome to the Black Swan Party. This is your bi-weekly analytical soiree to discuss the unthinkable, the highly unlikely, and sometimes even the Biblical. For example, on its face, the risk of nuclear war should be significantly elevated in the coming weeks. Not only is a Ukrainian offensive beginning against a beleaguered and battered Russian Army, but there was even a drone attack on Moscow yesterday morning.
Another line crossed that a year ago would have been unthinkable. But the market judges such likelihood, even though elevated, as still negligible enough to not affect the price much. There are many misconceptions about volatility — both in markets and in general. Don't be offended if the market doesn't share your personal definition of apocalypse. That will never happen.
And these misconceptions about volatility our species is prone to can be very costly in the business of managing money. Sometimes, they even can quickly render an institution insolvent, only recently considered a bastion of stability.
The reputation of volatility is draped in fear and traumatic memories for many people. In a financial context, though, it can be isolated and utilized to improve outcomes by discerning professionals. Hard as it may be to understand, volatility is amongst the most significant opportunities an abrasive and fickle market will ever present to you. There's a reason Citadel just rented out Disneyworld for a Sultan's fortune after a terrible year in markets, while most firms issued shabby bonuses, and some barely even got by.
There's a theme that I will keep returning to in this column. In colloquial terms, volatility in the markets evokes certain emotions in many people. That affects how we respond. We tend to associate it more with downside moves too, but as those holding Nvidia put options last week found out, it cuts both ways.
This recent event and the simultaneous outperformance of both long and short volatility strategies in 2022 lend credence to a recent theory I proposed explaining what might be 'getting the VIX down' despite many ostensible reasons for it to spike. Similarly, the fact that the bond market showed elevated volatility relative to the VIX suggests that its anomalous behavior indicates a changing market and new realizations. It is certainly not reflecting the tranquility of our times…
Financial volatility is counterintuitive and extremely difficult to comprehend. However, this is not just a property of financial volatility. Physical volatility and how it affects human behavior is often similarly challenging to comprehend or predict.
And though financial volatility is redolent of physical volatility, it is not the same thing. But many lessons about financial volatility can be gleaned from how humans respond to physical volatility because the two are enmeshed through human psychology.
Understanding the differences between the two and how the crowd responds to and perceives them each, respectively, makes the difference between you being a hero or zero in terms of portfolio returns, that is. Black swan events are rarely anticipated by anyone, and if they are, it is necessarily not ever very many folks. Explanatory bias often leaves us feeling that genuine Black Swan events were more predictable than they were in reality.
Also, humans tend to overestimate the risk of many low-probability events based partially on an emotional lens. In other words, risks that hit our 'fear bone,' so to speak, seem more likely to occur than they actually are. Our social backgrounds and the heuristics we use based on our experience all may cause blind spots, regardless of beliefs or social background. Human beings are human beings, which becomes all too evident in the teeth of a Black Swan event.
Memorial Day Special: Let's Dive a Little Deeper into the Idea of a Market Rout
The discussion of Black Swans may have gained a stuffy or prohibitive vibe to some in financial markets. I want to shatter that viewpoint with this column. We're not all Quants, but we don't have to use complex math for all our discussions. Thoughtful metaphors are one of the most effective ways to enhance human understanding of financial volatility, given the limitations of our brains.
Thus, I want to try to enhance your understanding of what a Black Swan event is and what a Black Swan event is not. The distinction is quite important if you're hedging a portfolio. For example, a typical bear market is NOT a Black Swan event! History shows it's as sure as winter is colder.
We may take military metaphors for granted, but I think the three outcomes of advance/attack, stay put, or retreat lend themselves quite well conceptually to understanding price. There are rapid advances enabled by maneuver, by attack, there's stalemated confrontation like in Bakhmut where maneuver is confined, and then there's the unmitigated panic of a rout.
One way to often achieve a rout in the enemy is by one of warfare's most analogous situations to the idea of Black Swans in financial markets: the surprise attack. Success is often based on a defender's assumptions that turn out to be painfully incorrect.
A great example is when T.E. Lawrence (Lawrence of Arabia) went on a treacherous desert route considered impassible by his enemy to capture Aqaba. In appearing behind the large naval guns that made the fortress so prohibitive, he quickly secured victory against stunned Ottoman defenders. Such attacks, like Black Swan events in markets, can result in swift and decisive reversals of fortune.
The nature of the Black Swan risk is that it always takes the impassable desert approach. It always shows up in our rear, where we often least expected it. We are all the Turks of Aqaba the day before the Black Swan reveals itself, knowing we are safe when we are truly vulnerable.
Black Swan Lesson One: Keep the Blood Cool
"In every battle, there comes a time when both sides consider themselves beaten, then he who continues the attack wins." Ulysses S. Grant
Sangfroid comes from the two French words for "cold" and "blood." However, it should not be confused with the common phrase "cold-blooded." In the 19th century, the term was especially associated with Napoleon Bonaparte's coolness under fire and his ability to pivot disaster into victory by steadily and accurately appraising the situation in the most trying circumstances. At Marengo, he saved near defeat by personally leading a charge; at Austerlitz, he turned the enemy's superior numbers against them brilliantly.
In the spring of 1862, General Ulysses S. Grant sent his army down the Tennessee River to a small backwater riverboat stop called Pittsburgh Landing. He was fresh off a few victories that provided a nice contrast to mismanagement in other theaters of the conflict. He had already garnered the name "Unconditional Surrender" Grant.
He was moving his army in position to march on Corinth, Mississippi, and the Confederate Army assembled there. While his army was first, the Army of the Cumberland under Don Carlos Buell was also marching to the same spot to link up with Grant before the planned move on Corinth.
One of Grant's principal deputies, William Tecumseh Sherman, had recently returned to service. He was written off as insane and given time to recuperate when he had boldly suggested it would take a couple hundred thousand men to suppress the rebellion in the Mississippi Valley area. History proved his concerns prophetic rather than insane, but he still wore a scarlet letter at this time. The last thing he wanted to be seen as was paranoid. Ever been early on a trade, but it eventually turns out you were right?
He and Grant indicated they did not expect an attack on April 5th. Sherman went to investigate claims of enemy movement, which he seemed to assume were the overblown fears of scared and histrionic new recruits. He went to investigate, and Confederate skirmishers emerged behind him, killing his orderly and his horse and wounding him.
Grant was nine miles away downriver and was sober as a preacher, contrary to subsequent newspaper accounts. He departed immediately when he heard cannons to assume command in person.
Men were at church services, eating breakfast, and performing other morning duties when the familiar interspersed cacophony of musket shots from soldiers skirmishing, practicing, or discharging their weapons after guard duty became a constant and terrifying thunderous rumble. Luckily, a Union officer had sent a patrol out before sunrise that devised the size of Confederate forces in time to avoid a complete surprise.
While newspaper accounts claimed Union soldiers were bayonetted in their tents while asleep, the truth was more complex. The Confederates were green too, and some of their units panicked and fled after meeting deadly Federal musket fire concealed by dense woods.
However, the weight of the Confederate concentration and the element of surprise pushed most Union forces back. Unit cohesion broke down as the two inexperienced armies smashed against each other at Dawn. Many brand-new Union soldiers retreated and cowered back at the landing, spreading false rumors of total defeat and urging their compatriots to flee for their lives. Some even began trying to construct makeshift rafts to get across the Tennessee.
By morning units had dissolved entirely in some places, and the opposing forces were the bravest of each army. A core of resistance formed around a sunken road that would later take on the nickname the assaulting Confederates had for it; The Hornet's Nest.
A stolid Union resistance formed here. It is made even more patriotic and harrowing because many of these men had never seen combat, yet their determination saved the day. Ultimately about 2,000 men were forced to surrender after enduring the largest concentration of artillery until then in the history of the North American continent and expending all their ammunition.
Yet, even in this act, they dulled the momentum of the Confederate advance as inexperienced soldiers went to gloat and gawk at the Union prisoners that had killed so many of their comrades.
But their brave stand that day dulled the Confederate attack enough that it could not succeed in the ultimate aims laid out by its architect, Albert Sidney Johnston, who was killed by a Yankee bullet around 2 pm. Before launching the attack, he had told his officers that their horses would drink water at dusk in the Tennessee River or in hell. The final attack on the landing, which could have brought ultimate victory, was stopped by a formidable defensive line and the help of large caliber guns on the USS Lexington and USS Tyler close by in the river.
The losses were unimaginable. And many great men in so many other respects could have been forgiven for losing composure in such a ghastly environment. Many would have ordered a retreat after seeing so many dead and mangled. Instead, Grant stayed up all night making preparations.
Sherman, who had been wounded twice, approached Grant, who was smoking a cigar in the rain under a tree.
"Well, Grant, we've had the Devil's own day, haven't we?" said Sherman to his commander.
"Yes," said Grant. "We'll lick em' tomorrow, though."
And that's exactly what Grant did. Buell's forces began arriving as the Confederates conducted their ill-fated final attack of April 6th. By morning the Union forces outnumbered their exhausted opponents, whose attack had also outpaced their supplies. The Union soldiers attacked the Confederates and shattered what was left of their army. They were forced to retreat in confusion and chaos back to Corinth.
You Know What Happens When You Assume
At the front end of every Black Swan event is an obsolete assumption. Its obsolescence has not yet been revealed by chaos. At Shiloh, that assumption was that the enemy was untrained, demoralized, and lacking in equipment and supplies. Because of this, Sherman and Grant thought they were safe from attack, maybe partially because, in their minds, they were the attackers.
Though some of their assumptions even had many elements of veracity, the enemy's desperation motivated his brazen action in defiance of considerable obstacles. Albert Sidney Johnston, the Confederate commander, likely knew his opponents, whose education and inclinations he understood, would not be expecting such an unprecedented action.
Grant and Sherman let the engineers plan the camps with regard to sanitation and closeness to necessities like firewood and water. Therefore, entrenchments and a more defensive posture were not undertaken, which could have deterred or quickly foiled the Confederate surprise attack.
This action seems criminal in the wake of the unprecedented orgy of violence at Shiloh, but the day before Shiloh, it would have seemed a lot more reasonable. One of the most immense burdens on the military so far in the young conflict was absorbing men with no relevant experience from civilian life into the military. Many Union soldiers at Shiloh had just arrived and had such little training that they could not march or fire their rifles, the latter a difficult task back then. Even more so under duress.
But this was not the mistake of buffoons, as Sherman's and Grant's subsequent successes prove. Sherman was regularly found up early in the morning, listening for enemy movement before his men rose later in the war—even the Titans of our past possess human frailty.
Furthermore, in the 19th century, the most significant cause of death was disease. Hence, the decision wasn't as silly as sensational newspaper accounts mainly derived from those who ran and continued cowering at the landing all day Sunday would suggest.
At the same time, the bloody first day of the battle played out between the attackers and those who did not flee. What has been portrayed as barbarous negligence was probably Grant and Sherman trying to ensure a bunch of greenhorn Iowa and Illinois farm boys didn't die of dysentery before they could make an attack on Corinth.
What Are We Assuming Today That Will Seem Foolish Tomorrow?
The obsolete assumption in the chaos engendered by the Asian financial crisis was that countries don't default. In the mortgage crisis a decade later, it was that people always pay their mortgages. Or you can always trust Triple A paper. A Black Swan is rarely something the market has been focused on for long before the big reveal. Whatever risk the market focuses on often has more bark than bite.
But now and then, and usually, quite suddenly, you're running for your life from a pack of mangey stray dogs. In early 2020, many probably assumed with some confidence that a respiratory disease emerging in Wuhan, China, was likely to end up similar to the Ebola scare of a few years before. The prospect of it causing millions of deaths and an unprecedented global economic shutdown was very low until the preponderance of evidence slowly revealed the severity of the situation.
Let's even look at recent events to determine the efficacy of investing by catchy but often detached and inaccurate aphorisms. Bank stocks do well in a high-rate environment! Nuance is as key to investing as stealth is to hunting. Aphorism and simplicity, tempting as they are, often betray valuable truths for those interested in wealth preservation during times of extreme peril.
The severity of black swan events in markets or the physical world is usually shocking and will almost certainly result in recrimination that obscures the truth. However, I'm more inclined to agree with famed Economist Hyman Minsky, who views financial instability as a necessary element of capitalist economies. Of course, Joseph Schumpeter, the man who denoted the term creative destruction, thinks these destructive market cycles are necessary for the miraculous growth enabled by technology.
As far as we know, the effects of financial panics and hysterical sell-offs may be mitigated but never eradicated. For 3,000 years, the Western world only thought that there were white swans, though, as John Stuart Mill adeptly pointed out.
Part of what a Black Swan event is is something occurring that was considered outside the realm of possibility by the consensus before it was observed. Human intellect is not good at grasping rare events and is even less adept at grasping events without precedent. This is particularly true amid such events when the reliability of our limited rational abilities becomes compromised.
This qualified the ghastly Battle of Shiloh as a Black Swan event to those who experienced it, but a black-necked white swan in retrospect. The losses of life and limb there exceeded the losses of all previous armed conflicts involving the United States. Faulty intelligence, untrained soldiery, and overconfidence on the part of commanders all contributed to the dramatic unfolding of events. But here is a critical distinction also in the nuanced parlance of Black Swans.
Beware of the Black-Necked White Swan: Get The Whole Picture
Often the quest for blame in the wake of Black Swan events, legitimate as it may be in some instances, discourages the reasoned search for ways to avoid their impact on portfolios. It distorts our understanding and perception of those events, which is made worse by our retrospective vantage point and an inherent desire for ordered narratives. But ordered narratives fail to capture the full prodigiousness of chaotic events.
Everything we know about modern financial markets, since their origin in the 17th century in the low countries, indicates that the undulation of price between excessive optimism and excessive pessimism is a perennial feature. So those natural fluctuations in price and the natural bubbles that occur are distinct from sporadic events like Black Monday in 1987 and COVID-19.
Shiloh is an excellent example of how sometimes the Black Swans of the present are merely turning points, signaling that the future will be more similar to them than the past was. In the instance of the Civil War, this realization was bleak for our country. There were almost 25,000 casualties at Shiloh, an unthinkable statistic on April 5th, 1862.
By 1865 though, the unthinkable carnage of Shiloh had become routine, even quaint. More than twice as many men fell at Gettysburg. Perceiving whether an event is an anomaly or the bookend to a past age is our conundrum in the heat of the moment.
If the increasingly recalcitrant leader of Russia's paramilitary group, Wagner, suddenly seized tactical nuclear weapons in Belarus and used one on a Ukrainian airfield the decision you would have to make rather quickly would be: is this an anomalous event, or is this signifying a new era where nuclear weapons use has lost its taboo? Was it just an excuse for Putin to try and fumble the West's response? Are more coming? Rumors are flying, and you have to make a decision. Should you buy stocks or hide in your basement and take potassium-iodide pills?
Why Sangfroid is Crucial (Don't Assess Risk Like a Fish)
The human brain is a complicated organ with varying parts whose origins stretch across the arc of evolutionary time. These conflicting, duplicative, and outdated processes occur all at once. It is an art to isolate truth from them. Our complicated parts distinguish us from the animal kingdom, our higher impulses. However, we also share much biology with the animal kingdom we so quickly exalt ourselves over.
One of the most primitive, powerful, and rapidly responding parts of the brain is the amygdala. This organ responds nearly instantly to sensory information and floods the mind with a cocktail of chemicals responsible for emotions like anger, defensiveness, and, most crucially: fear. It engages the notorious fight-or-flight response. But a fish or a lizard has this same response. It's remarkably similar.
What humans have that our less sophisticated animal kingdom family members do not have is more advanced parts of our brains, responsible for our highest achievements and best thinking. Our neocortex is where much of this fantastic reasoning and analysis takes place. If you're wandering through a jungle or perhaps fighting in the undergrowth near Pittsburgh Landing, your amygdala is your best friend.
If you're processing a situation with the complex interplay of multiple independent variables, then you want to use the more advanced parts of your brain. But these parts of the brain often require you to disregard the more immediate primitive signals you're receiving. They require you to take time to consider, analyze, and weigh evidence. Of course, right when it feels like you have no time.
Use the part of the brain that allowed Grant to perceive that although his men had nearly been defeated, the enemy's exhaustion must have been just as bad. Even worse when factoring in the new troops. He'd likely not have been able to make that crucial realization for the Union had he listened to his amygdala and thought like a fish.
Don't assess risk like a fish. Remember when you're looking at a sea of red charts that there is likely a way out, perhaps one that puts you ahead of where you'd been had the event causing the red never transpired. Whatever the Black Swan risks we will face in the future; it will be better to face them with sangfroid.
