THE BLACK SWAN EVENT

A Black Swan is an event that is a sudden development of a situation which is beyond

expectation and has dire consequences. It is such an event which is very swift, has severe
impact on financial markets and masses are affected with the hindsight. The term is
popularized by Nasim Taleb’s book called ‘The Black Swan’ which was written before the burst
of housing price and Sub Prime Mortgage crisis of 2008. In 2007, it talks about the coming
financial crisis though known to many but ignoring the facts and following the current frenzy
in housing and stock markets. After the bubble is burst, realising during the end of 2008, in
hindsight it was already known to many about the causes to the event.

A Random Walk Down to 2008 Crisis:

Though the financial crisis of 2008 is so rare and had a catastrophic impact but it was
predictable as could the writer, Nasim Taleb. The system was broken, still allowed to fail until
Lehman Brothers filed bankruptcy as on 15th September, 2008 at the time when Dow Jones
Industrial Average (DJIA) Index was at 11400. It was the straw that broke the camel’s back.
Interpreting from the stock market perspective is that the Bear market begins quietly with a
gradual fall and fast pullback corrections. Quantum of fall is slower and longer days with fast
pullback of shorter days. Here the prices decline much more in percentage than the rise. The
feel-good factor prevailed with buy on every fall because markets always gave profit after
every fall with higher volatility, making general investors complacent. Eventually DJIA
bottomed out at 6626 (2nd March, 2009).

Technically, the impulsive wave of bear market of DJIA started from 14100 (8 th October, 2007)
to 11900 (3rd March, 2008) and corrected to 13100 (28th April, 2008). The last impulsive wave
started from 200 DMA level of 13100, with 5 sub waves (A, B, C, D, E) can be seen in the chart
below:
In March 2007, the housing sales started to fall gradually and housing prices steadily slid till
the last quarter of 2007, then it finally burst in 2008. The global economy was slowing down
and system was broken could be found evidently from the crisis brewing around us but
defying it. Following are the events before the final collapse:
A. Falling sales and prices in housing market in 2007
B. Fannie Mae and Freddie Mac financial institutions constrict their lending by December
2007
C. Several banks and financial institutions across the globe started showing huge losses
D. BNP Paribas warning investors that they won’t be able to withdraw funds in August 2007
E. Northern Rock (UK) was seeking emergency funds from Bank of England during mid of
2007
F. Ireland economy had shown signs of impending recession
G. Two Bear Stearns hedge funds collapsed in March 2008
H. Steep fall in housing prices after first quarter of 2008
I. Lehman Brothers collapsed in September 2008

From the charts above, it can be easily verified that DJIA peaked till October 2007 then fell
heavily till March, 2008. The fall was not steeper but “a death cross” happened on charts as
50 Daily Moving Average (DMA) a blue line crossed over 200 DMA (red line) by December,
2007, indicating the beginning of a bear market. After a fall, an upward correction till 200
DMA a red line became a resistance. It was the event where JP Morgan bought out the failing
Bear Stearns creating a false optimism in the stock markets. Markets knew something
unknown to general investors who were complacent. The Black Swan event was when
Lehman Brothers filed bankruptcy in September, 2008 then there was a steep fall and
relentless selling by the investors. The prices in stock market dictate the sentiment and not
the event. A sharp fall makes the general investors jittery at the time when they give up the
stock markets.

In context to today’s scenario:

Inflation in US is at 8.5% for the month of July, 2022 and interest rate at 2.5% per annum. The
negative real interest rate is 6% (8.5%-2.5%) which is horrendous. The key highlights of
Jackson Hole meeting are:
1. US Fed would hike interest rate to 3.25% by September, 2022 and further up in coming
months
2. US Fed mission is to deliver price stability by bringing down inflation to 2%
3. US Fed Chairman said that it will bring pain to households and businesses which is the
unfortunate cost for reducing inflation.
US Fed is not just hawkish but determined to bring down inflation at the cost of the growth,
ultimately it means a death knell.

From March, 2022 interest rates started going up from 0.25% to 2.5%. It becomes the
sharpest increase in interest rate in the past 40 years and still no reason to stop. What does
it mean? Interest rates are going above February, 2008 level of financial crisis. Faster
monetary tightening and steep increase in interest rates would lead to next economic crisis
which would far greater than the financial crisis of 2008 because money printing is 15 times
more than what was in 2007.

According to the US Census Bureau and the US Dept. of Housing and Urban Development, the
median sales price of new houses sold in July 2022 was $439,400. The average sales price
was $546,800. In 2022, the housing sales started to fall gradually and housing prices steadily
sliding just like scenario of 2007. The global economy is slowing down and system is breaking
down with the crisis brewing around us but defying it. Following are the events happening
around us before the final collapse:
A. Warning by Jamie Dimon (JP Morgan) who said, brace yourself for an economic hurricane
caused by the Fed and Ukraine war.
B. Russia Ukraine War leading to higher prices of crude oil, natural gas, food & fertilizers.
C. Climatic conditions leading to scarcity of food and water.
D. Geopolitical tension between several nations.

Technically, the impulsive wave of bear market of DJIA started from 36800 (4th January, 2022)
to 29900 (17th June, 2022) and corrected to 34150 (16th August, 2022). The final impulsive
wave started from 200 DMA level of 33900, with 5 sub waves (A, B, C, D, E) shall be seen in
the future as shown in the chart below. We have not yet witnessed a black swan event.

Comparison to charts above with charts of 2008:

a. Currently at the stage of April 2008
b. Bad economic conditions
c. Very high inflation
d. Corporate profits taking a hit in major sectors
e. Faster increase in interest rates with monetary tightening
What could be the next Black Swan Event?
Europe zone could be the possible Black Swan event which may unfold in coming winter
season. The impact of Russia Ukraine war could turn into worst possible scenario as the war
is not between Russia and Ukraine but Russia and NATO.

Europe is hemmed between USA and Russia tension. May be a decade or more, there were
good relations and economic cooperation amongst Germany, Russia, China, France and Italy,
due to which there is greater inter dependence of the economies. Germany, China, Russia
and Gulf nations were very much interested in the infrastructure project called ‘One Belt One
Road’, conceptualized by China in 2016. The supply of natural gas through Nord Stream 1
(completed) and Nord Stream 2 (near completion) from Russia to Germany was one great
step towards clean energy and greater economic cooperation. The Trump administration in
January, 2021 imposed sanctions on the Russian counterparts related to Nord Stream 2 gas
pipeline. Eventually political interference started in 2019 by US for desolation of Nord Stream
2 and One Belt One Road (OBOR) initiative. Financial markets are very much intertwined
between US and Europe. Almost 36% of German gold is stored in the vault at the headquarters
of the Federal Reserve Bank of New York, 80 feet below street level, 12.8% in London and
2.7% in Paris. The sovereign decision of Germany to join Nord Stream 2 and OBOR stands
weak as US Dollar dependence and almost half of gold is held with prominent NATO members
who are also part of UN permanent security council. Germany is the leading economy in
European region followed by UK and France.

The fall out of Russia Ukraine war is politically spilled over to entire world. Ukraine accounted
for 10% of global wheat exports and 40% contribution to World Food Program. Russia
produced about 17% of all wheat globally. 2 nations together contribute 28% of global
fertilizer exports. Exports from Ukraine has dwindled due to war, therefore supply shortage
creating a food inflation, being Ukraine the major exporter of food items. US and Europe have
put several economic sanctions on Russia which has resulted into sharp rise in inflation
because of drastically reducing the supply of natural gas by Russia, thus higher demand for
crude oil. The price of cooking gas has shot up more than 6 times in Euro zone. There are
several measures taken by many countries in Europe to rationalize the energy needs by
prioritizing the supply. People are stocking up firewood as the price of natural gas has shot up
and possibility of no gas supply during winters. Europe has sunk into deep energy crisis.
Germany’s Federal Firewood Association said that the market is all out of wood. Now
Germany is looking to import firewood as demand is high and wood unavailable. Chemical
factories are shutting down, gas supply companies are either getting bailed out or
nationalized and soon automobile and other industries shall be asked to curtail down the
production as the energy supply to citizens is top priority. It shall be ‘a supply shock’ inflation.

As the inflation is at record levels in Euro zone, it becomes a compelling situation to increase
interest rates faster and reduce money supply to curb high inflation. Money supply created
in last one decade is at historic level and there is need to do quantitative tightening. It shall
be a double whammy. Imagine the impact on financial markets where housing prices and
stock markets are still high comparatively. Climatic conditions are equally bad in Europe. Loire
river of France and Po river of Italy almost dried up. It is the worst drought in 500 years. Two
third of Europe is under drought. Water scarcity and food shortage shall lead to hyperinflation
and unrest of civil population. There shall be huge government deficits in Europe. Following
are the adverse conditions visible in near future for European countries:
1. Dwindling exports
2. Rising demand for food and goods, higher imports
3. Domestic industry shall be short in supply due to low energy supply
4. Weakening of Euro currency due to huge current account deficits
5. High inflation
6. Falling corporate profits
7. Current account and fiscal deficits
8. Sovereign Debt crisis
9. Civil unrest
10. May be worsening situation to call a war against Russia to negotiate on energy
problems

Conclusion:
Like the most economists it is understandable and given hindsight, totally predictable. Still
the general investors are complacent just like in 2007 even after knowing the economic
hurricane is coming. Prices decide the sentiment though the event becomes irrelevant till the
prices justify the same to name the reasoning is a black swan event.

A black swan is rare to be found as the swans are white and once found then the thought is
that it is no more rare. When the rare event happens which is unforeseen and catastrophic,
the stock markets fall more than unrealistically leading to irrational valuations, becomes a
dead buy.

By Ankur Sharda
Published on 3rd September, 2022