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Coronavirus Is A Black Swan Event; You Need To Explain This To Your Clients

Coronavirus Pandemic Classic Black Swan Event

In the last months, we have lived through heart-stopping moments of a “Black Swan” event because the market had an unexpected and unannounced visitor.  The ups and downs of the stock market since have been a bit stressful especially to those in the industry.

By definition, Black Swan events are impossible and can’t happen. The expression comes from Medieval Europe when no one believed black swans existed. [1] In the financial business, Black Swan events are never predicted and thought to be impossible. But they aren’t, and they come out of the blue and wreak havoc on the markets.

A Pandemic Will Arise and Cause a Bear Market? Are You Nuts?

Who could have anticipated an unknown virus would appear and cause a global pandemic, which would cause major losses and turmoil in the financial markets in such a short period?

Further, who could have predicted that by late March, most people in the U.S. would be sequestered in their homes by emergency orders? The entire scenario seemed is impossible. But the impossible happened anyway.  That’s why it’s a Black Swan event.

Three Recent Black Swan Events: Wall Street Survived Them All        

1. Black Monday, October 1987 Market Drops 22% In One Day

​On October 19th, 1987, or “Black Monday,” the Dow Jones Industrial Average lost 22.6 % of its value in one day, the largest one day drop in its history. [2] Financial Advisors had never experienced anything like it, and no one, no matter how prominent, had any idea what to do. But the market survived.

2. 2008 Great Recession Almost Took Down International Banking System

In the financial crisis of 2008, could have developed into a repeat of the Great Depression but didn’t thanks to swift action by the Fed and the Treasury and with generous contributions from taxpayers.

Storied firms that had been in business for decades suddenly and without warning informed the Fed and the Treasury Department that in a few days, they would collapse because they had burned through their capital reserves.

Such an emergency never before had faced the Treasury or the Fed. Fortunately, they intervened decisively, and the international banking system remained intact, but the crash caused a ten-year bear market as massive de-leveraging occurred. [3]

3. Long Term Capital Management  

Founded in 1994, this was supposed to be the best hedge fund ever. For a few years, it seemed like it might be. Led by two Nobel prize winners in economics, it attached more than five billion in capital. Employing a complex derivative strategy, the fund leveraged up until it controlled about 100 billion, and more derivatives were piled on top of that sum as time went on. [4]

Sovereign Default by Russia

Long-Term Capital Management (LTCM) had invested a large amount of money in Russian government bonds. Sovereign default is unusual since it closes off international capital markets to nations that have defaulted.  LTCM thought Russia would not default on its bonds. But they did.

That was the beginning of the end for LTCM. The New York Fed “asked” 14 banks to come up with a rescue fund so LTCM could unwind all of its positions and not cause a global financial crisis. It worked out in the end. [5]

We have survived all previous Black Swan events, and we shall survive this one. But, you must reassure your clients we will survive this one just as we survived the others.

 

Resources:

[1] https://en.wikipedia.org/wiki/Black_swan_theory  (Black swans are found in Australia so they do exist).

[2] https://www.federalreserve.gov/pubs/feds/2007/200713/200713pap.pdf

[3] https://dealbook.nytimes.com/2008/09/21/goldman-morgan-to-become-bank-holding-companies/

[4] https://www.investopedia.com/terms/l/longtermcapital.asp

[5] https://www.richmondfed.org/-/media/richmondfedorg/publications/research/econ_focus/2009/summer/pdf/economic_history.pdf

 

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Contributing Writer: Subject Matter Expert Charles McCain