Swans Come In Different Colors

A black swan is an exotic ornamental specie with an estimated global population of about half a million. These birds are protected and really rare. Given their rarity, financial markets have too adopted the term Black Swan to an event that is abnormal, has a wide-spread impact, and is both difficult to have predicted yet it becomes rather obvious with the benefit of hindsight.

Where The Term Comes From?

The term ‘black swan’ became popular after the publishing of the book The Black Swan: The Impact of the Highly Improbable by finance professor and former Wall Street trader Nassim Nicholas Taleb.

Taleb described a black swan as an event that is unpredictable in that nothing in the past may have suggested to its occurrence, one that has potentially dire consequences and that it can rationally be explained after the fact.

Black Swan became the popular term, one that served to capture most if not all abnormal events in the market. These days, however, that’s no longer the case. We’ve evolved to break down ‘swan-type’ events into three colors.

Swan Colors: White, Grey & Black

You see, some market participants started to, rightfully so, make distinctions among all these seemingly weird events. The reason? Not all events with extreme repercussions were necessarily unforeseen. Some were known events that could happen and therefore one could assign a small probability.

From there, the terms grey and white swans came into existence. The main difference resides in the probabilities of these happening. While a grey-type is portrayed at greater odds than a black swan from happening, the white event is seen as almost a certainty that at one point or another will occur. In this latter, it is also viewed as an event that won’t have widespread effects.

In a nutshell, independent of the number of individuals affected, the main difference between a black swan and the variations born afterwards, lies on one happening out of the blue vs the others known in advance.

Examples of grey swan events include Brexit, a term coined by the departure of Britain as a member of the European Union or Donald Trump becoming the US President. The outcome of these types of events cannot necessarily be predicted with ease, even if the popular belief at the time perceived it as rather small probabilities, hence the opposite outcome represented an outlier.

Landmark moments of black swan events include the extreme stress in the global economies amid the bursting of the U.S. housing bubble in 2009, the near implosion of the EU banking system in 2013 that led to the Cyprus bank disaster, the 2011 Tōhoku earthquake and tsunami in Japan, or more recently the dire effects of Covid-19 when economies suddenly stopped.

By and large, abnormalities in financial markets, have its root cause on either natural disasters, politically-led decisions, or alternatively, these events can be triggered on the back of complex financial wrongdoings.

There is also a clear benefit in anticipating a non-black swan. This has to do with the choice to mitigate the foreseen risks ahead. Non-black swans allow to draw up some form of a plan on how to potentially handle these eventualities, whereas in a black swan, the herd must play catchup with little room for prep.

As an example, on the lead up to Brexit, one could have engaged in the activity of buying/selling out of the money options to protect the downside in the sudden loss of valuation by the British Pound.

Now think about Covid-19 and how firms all over the world were almost overnight exposed to a liquidation event due to the shortage of USDs across the world as panic for immediate funding got out of control.

Uncharted Waters = Danger Of Darker Swans

In many respects, we live in an unprecedented era where the risks of strange market occurrences have increased exponentially in line with the decade-plus experimentations in hyper money printing aka quantitative easing.

The tools and policies deployed by central bankers have created a legacy of hidden distortions and unforeseen consequences in the system.

These heightened risks of abnormal events were really turbo-charged in the 2008 GFC. It kickstarted a mad explosion in the size of Central Banks’ balance sheets. These reforms to unorthodox policies that followed ever since sparked an extremely and profound behavioral shift in risk taking and (mal)practices.

The exponential increase of events out of touch with normal reality or simply put just plain weird, even aside from what’s been categorized as swan-type events, are also scary and red flags are found everywhere.

The notorious story of an army of redditors putting powerful hedge funds belly up in a bet to defy the status quo is a classic by now. While it can’t be classified as a swan event, it was certainly as abnormal as it gets.

The movement, at its core, was born out of the anger and frustration by a growing number of average traders/investors sick and tired of the widening wealth gap caused by the effects of such unorthodox Central Bank policies. That’s definitely something you wouldn’t believe 10y ago, right?

How about the disconnect between stock prices and the true fundamental valuation? That’s another one that speaks loud and clear about how liquidity is the oxygen the market is craving for and sustained by. Even if by now we’ve grown so accustomed to it that is has paradoxically become the norm and not a rarity. These events are just the tip of the iceberg. One can dig much deeper!

Again, as an interconnected web of economies navigate through unchartered waters, it can more easily lead to shifts in normal conducts. The reasons and motivations can vary wildly, yet the end outcome, is that it significantly increases the chances of unknown or abnormal events taking place.

But regardless of the weirdness of events that have happened or are yet to see the light, there is a dominating force at the center of it all, one that controls it all, even if they are trapped in what appears to be an inescapable loop. I am referring to Central Banks. They are the magic hand that stealthily lays the foundation for swan events to revisit us, while paradoxically, preventing these anomalies from truly getting out of hand.

As noted, an inescapable loop with no easy way out.

The Plunge-Protection Team

In swan events, should not be for the plunge protection team aka Central Bankers (Fed, ECB, BoE, BoJ…) and the liquidity provisions they constantly injected into financial markets at times of extreme uncertainty, well, it is best not to imagine what a dramatic picture that would be for the global economy.

Granted, it was the unwillingness to let normal market mechanics and organic price discovery determine market valuations when the proverbial hit the fan through the GFC, that truly led Central Banks to embark on a progressively transformative market phase, a state of irreparable ‘liquidity-craving’ mania.

These powerful institutions have become the market. They’ve created the biggest disconnect between true fundamentals and valuations in recorded history. Without their relentless interventions, global economies would have suffered badly at the peak of the GFC, but it has come at the cost of greater and greater abnormalities in the normal functioning of market dynamics.

The irony is that Central Banks, the very institutions meant to promote economic growth, maintaining full employment, preserving financial stability, and defending the domestic currency, have gotten so involved in the plumbing of liquidity dynamics, that their outreach has perpetually distorted how markets functions, and with it, comes the unintended risks of living dangerously by the growing prospects of swans of all forms and colors.