Black Swans

This blog post originally appeared on RealMoney Silver on June 14 at 8:00 a.m. EDT.  {Excerpt with my highlights.}

"Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words, it creates devastating Black Swans...... The increased concentration among banks seems to have the effect of making financial crises less likely, but when they happen, they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur ... ...I shiver at the thought. Banks hire dull people and train them to be even more dull. If they look conservative, it's only because their loans go bust on rare, very rare occasions. But ... bankers are not conservative at all. They are just phenomenally skilled at self-deception by burying the possibility of a large, devastating loss under the rug.....

The Achilles' heel of capitalism is that if you make corporations compete, it is sometimes the one that is most exposed to the negative Black Swan that will appear to be the most fit for survival.......As if we did not have enough problems, banks are now more vulnerable to the Black Swan and the ludic fallacy than ever before with "scientists" among their staff taking care of exposures.

Owing to ... a misunderstanding of the causal chains between policy and actions, we can easily trigger Black Swans, thanks to aggressive ignorance -- like a child playing with a chemistry kit."

-- Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable.  

The new normal is abnormal and is bound to haunt investors for some time to come.

....I am referring to the new normal of disproportionate, high-impact, hard-to-predict rare events beyond the realm of "normal expectations in business, history, science and technology" that are occurring with startling frequency......

Risks of black swans, previously perceived to be small by corporations, investors, politicians and regulators, are now being reassessed, owing to (among other issues) globalization, tighter correlations, advancements in technology, the growing/excessive complexities of interlocking supply chains and derivatives, the acceptance of greater/extreme risk-taking ("the longer people make money by taking risk, the more imprudent they become," the Minsky moment), the greater connectivity of increasingly more complex systems (see Paul Ormerod and Rich Colbaugh) and so forth.

A greater and more dynamic instability is the new normal. Witness some of these historical black swan events over the past decade:

-the September 11 attack on the World Trade Center;

-financial derivatives roil the world's banking system and financial markets;

-the failure of Lehman Brothers and the sale/liquidation of Bear Stearns;

-BP's (BP) Gulf oil spill; and

-the market's flash crash (a 1,000-point drop in the DJIA on May 6, 2010).

....We can no longer turn the clock back to a simpler time. We must play the hand we are dealt.  For years, investors have been blinded to the uncertainty and unaware of the broad effect of the rare, black swan event, but we now know that these black swans (which seem to be occurring with greater regularity) are not only growth-deflating but, more importantly, are valuation-deflating.

The world is interconnected, interlinked and increasingly complex. It faces numerous structural issues (e.g., extreme fiscal imbalances at the federal, state and local levels), with governments (here and abroad) not necessarily up to the task of dealing with the complexities. Given the "newness" of these and other challenges as well as the greater frequency of black swan events, P/E multiples are being pressured and should continue to contract as a comparison between today's valuations to those of history can be expected to lose some of its significance Again, it's different this time.

While the above valuation comparisons are based on historical experience, similar to the belief in bell curves, they should be used with caution because, in all likelihood, another black swan will appear on our investment doorstep ... sooner rather than later! In this setting, a more conservative asset mix and higher cash position than normal seems to be the prudent strategy.

Doug Kass writes daily for RealMoney Silver, a premium bundle service from TheStreet.com. For a free trial to RealMoney Silver and exclusive access to Mr. Kass's daily trading diary, please click here.

Link: Black Swans Return