As the novel coronavirus (Covid-19) pandemic continues its dangerous spread around the world, Wall Street investors are becoming more risk-averse by the day.
The pandemic looks set to have a significant negative impact on the global economy, companies, and financial markets.
At this point, most market analysts are bracing for the possibility of the global economy heading for its worst year since the financial crisis of 2008.
According to a recent note issued by Sequoia Capital, one of the world’s leading venture capital firms, the coronavirus pandemic is “the Black Swan of 2020.”
But what exactly is a Black Swan event? Why do they happen? How should you trade during a Black Swan event?
What is a Black Swan event?
A Black Swan is an extremely rare and difficult-to-predict event or occurrence that deviates beyond what is normally expected of a situation, dramatically altering the course of history, economies, and history.
The term “Black Swan” was coined by a finance professor and former Wall Street trader, Nassim Nicholas Taleb in his 2007 book “The Black Swan: The Impact of the Highly Improbable.”
It derives from the ancient (Western) belief that all swans are white, a notion that was proven false when Black Swans were eventually discovered in Australia by Dutch explorer Willem de Vlamingh.
Black Swan events can have both positive and negative results, especially in financial markets. Examples of positive Black Swans include the arrival of the internet and the rise of personal computers.
According to Taleb, all Black Swan events are defined by three attributes:
- They go beyond normal expectations that are so rare that even the possibility that they could actually happen is a mystery
- They are explained in hindsight as if they were actually predictable
- They have a drastic impact whenever they do occur
Examples of Black Swan events
The dot-com bubble of 2001
An economic bubble exists when the price of an asset (e.g. stocks, real estate, bonds, or commodities) rises rapidly, then dissipates. Bubbles happen when prices are justified by the overexuberant behavior of traders rather than the asset itself.
When there are no more traders willing to pay the overinflated price, people panic and sell and the bubble bursts.
The dot-com bubble, also referred to as the Internet bubble, began in April 1997 and ended in June 2003. During this period, traders pumped money into newly launched Internet companies in the hopes that these startups were going to be worth millions.
Unfortunately, many dot-coms were wildly unprofitable and most of them ended up collapsing. By 2000, the Nasdaq had crashed, there was talk of a recession and stock traders had to find jobs.
The terrorist attacks on September 11, 2001
The September 11, 2001, terrorist attacks on the World Trade Center and the Pentagon can be categorized as Black Swan events as they were sudden and unexpected. Not only did the attacks cost some 3,000 lives; they also struck the military and financial centers of the United States.
The New York Stock Exchange and the Nasdaq exchange did not open for trading on the morning of the attacks and remained closed until September 17 – the longest shutdown since the Great Depression.
Other stock markets around the world were shut as well. On the first day of NYSE trading after the attacks, the Dow Jones industrial average fell 7.13%, or 684.81 points to close at 8,920.70.
The 2008 global financial crisis
Another example of a Black Swan event is the global financial crisis of 2008. The crisis began in the mid-2000s when U.S. banks sold too many mortgages to feed the demand for mortgage-backed securities sold through the secondary market.
In 2006, home prices tumbled, triggering defaults and sending out huge ripples that greatly crippled the financial industry both in the U.S. and around the world.
This forced, Lehman Brothers (a prominent investment bank) to file for the largest bankruptcy protection in history in September 2008.
Not only did the filing send out the message that no institution was too big to fail, it also shocked consumer confidence in the economy. The impact of this event hit most countries and was severe on a global scale.
This crisis was a Black Swan because hardly anyone could have imagined the adverse impact it would have on the world economy.
The Covid-19 pandemic
As previously mentioned, some people on Wall Street believe that the novel coronavirus (Covid-19) pandemic is the Black Swan of 2020. The flu-like virus, first identified in the central Chinese city of Wuhan, in December 2019, has infected tens of thousands of people and killed several thousand.
Covid-19 has wreaked havoc on the global economy, causing financial-market routs not witnessed since the 2008 global financial crisis and raising concerns that the global economy is heading towards a recession.
No one could have predicted when exactly the next pandemic would hit or whether it would be the thing that ended the longest-running stock bull-market in American history.
How to trade a Black Swan event
As earlier mentioned, Black Swans are unpredictable. When they happen, they often take us by surprise and have major effects as a result. But since these events will always be a reality, here are a few tips for trading during a negative black swan event.
- Hedge your portfolio
One of the best ways to protect your investments when a negative Black Swan hits the market is by hedging your portfolio. Hedging is a strategy designed to minimize the risk of adverse price changes for a given financial instrument.
Whether you are picking individual stocks or ETF investing, you can use a variety of hedging strategies to reduce downside risk, as well as other risks. For example, if you wanted to hedge a short stock position you could purchase a call option on that stock.
If your equity portfolio is well-diversified and you strongly believe that the stock market will sink anywhere from 4% to 7% over the next four months, a hedging strategy that costs less than 4% could be worth considering.
- Look for stable blue-chip companies
Blue-chip is a name given to stocks of well-established companies, with a reputation for financial stability, reliability, and quality. These stocks have market capitalizations running into billions of dollars and are usually the market leaders in their sectors.
Blue-chip stocks tend to provide a sense of security and tend to “survive” and recover during market meltdowns. It is also important to remember that a falling stock price doesn’t mean that the company is going out of business.
- Add small positions – don’t go all in
Some Black Swan events may cause bear markets that give traders a great opportunity to buy stocks that are in a free fall.
While this represents tremendous opportunities to make money, it is not always good to on a stock-buying spree as you could end up losing everything if the market crashes.
It also makes sense to take your money out of the stock market if you think there is a higher chance of a substantial move to the downside, even if it means that you have an equal chance of missing a huge gain.
While not all such Black Swan events have negative consequences, very often they cause high-impact, catastrophic damage. However, there are a number of steps that traders can take to prepare for turmoil and protect their portfolios.
For example, keep an eye on indicators such as the CBOE Volatility Index (VIX) or Treasury yields to measure market volatility.
The VIX, known as “Wall Street’s fear gauge,” tends to rise during periods of unmitigated selloffs and extreme volatility.