Getting Ready for a Black Swan

The biggest stock market surprise could be an unexpected economic rebound.

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Successful investors take account of all known economic facts, but also try to be prepared for the most unlikely events. And as bad as trends look right now, it actually wouldn’t be impossible for the economy to surprise everyone with a rebound over the next 12 months.

That would be terrific, of course, but it could still hurt the long-term returns of defensive investors if they have cut back their stock holdings too much. Missing initial gains at a key stock market turning point permanently damages your long-term results. So if you have hunkered down, great news for the economy could be bad news for your portfolio.

(MORE: President Obama Talks Economy in Iowa)

In his best-selling book The Black Swan, risk analyst Nassim Taleb considers the kind of unexpected events that occur rarely but have an enormous impact. He calls these Black Swans, after the classic philosophical puzzle that says no matter how many white swans you see, you can never be absolutely sure that the next swan won’t be black. For investors, events that can’t be anticipated are usually the ones that have an outsize impact on returns.

Right now, most forecasters think the economy is bad and getting worse. And even Federal Reserve chairman Ben Bernanke says that a full recovery will be “painful and slow” and describes the outlook as “frustrating.”

But what if they’re losing heart at just the wrong moment? The underlying economic trends aren’t as terrible as the most visible statistics. And some economists think that the Fed has already done as much to stimulate the economy as it needs to.

(MORE: Selling a New Stimulus)

One thing most forecasters seem to have forgotten is that an important election is approaching. In normal times, we would be in the middle of a stock market boom because Presidents usually try to get bad economic news out of the way early in their terms and then pump things up in the 18 months or so before the next election.

The typical result: The stock market returns less than 5% from October of the first year of a President’s term through September of the second year, but more than 25% over the following 12 months. Indeed, the Administration and the Federal Reserve have been trying mightily to stimulate the languishing economy – so far with little result – but who’s to say they’ll keep failing forever? What if all the past stimulus suddenly kicks in?

Corporate profits would pick up disproportionately. Productivity would soar, because companies would sell more but be slow to rehire. And there would be little pressure for higher wages. Blue chips would benefit, and so would the creditworthiness of companies that issue high-yield corporate bonds and preferred shares.

The Federal Reserve would no longer need to keep holding down interest rates. And a pickup in economic growth would likely push interest rates higher. Essentially, this is the same scenario I described in my recent column on Treasury bonds, except that it would unfold much faster.

So what’s the best Black Swan investing approach? Keeping a lot of money in cash is the wrong conservative strategy, because of the stock market gains you would miss if the economy does bounce back. Treasury bonds look like an even worse choice since they offer anemic yields and would suffer price declines if a stronger economy pushes up interest rates.

Instead, favor high-yielding blue chips, since those stocks are paying more than Treasuries and are less vulnerable to a credit downgrade than the U.S. government is (as bizarre as that sounds). If you need some fixed-income investments in your mix, consider a mutual fund or an exchange-traded fund (ETF) that holds high-yield bonds or preferred shares. The above-average yields on such corporate debt offer a cushion against an uptick in interest rates.

At this juncture, you can in fact have things both ways, minimizing your likely losses if the economy remains moribund but profiting if the stock market surprises everyone and rallies. And you won’t have to worry that your next encounter with a Black Swan will make you crazy.

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