What to Expect in the Aftermath of a Black Swan

Black swans are comprised of three components: an outlier event, catastrophic impact and an explainable narrative afterward. In financial markets, a black swan event is akin to a lit matchstick in an already kerosene-soaked warehouse. In other words, there was already stress fractures that have been building up to that moment of collapse and the black swan is the tipping point that unleashes a perfect storm of catastrophic consequences. The coronavirus is the black swan of 2020 as the catastrophic consequences continue to ripple throughout global economies and financial markets. Here’s what to expect in the aftermath of a black swan event.

The Outlier

The World Health Organization (WHO) officially declared the novel coronavirus (COVID-19) a pandemic on March 11, 2020. The S&P 500 index S&P 500 (NYSEARCA: SPY) has broken many records including the fastest market decline in history collapsing nearly 27-percent from all-time highs of $339.08 on Feb. 19, 2020 to an intraday low of $247.68 on March 12, 2020, in just 16-trading days. Equity futures markets saw its first lock limit halts both down and up since the 2008 financial meltdown in addition to the largest single-day price swings in history.

Hidden in Plain Sight

Preceding a black swan, the compounding stress fractures are often hidden in plain sight but ignored due to public complacency. During the internet bubble of 2001, investors were aware of the insane valuations of internet companies but justified them since markets were validating an unprecedented new technology by soaring to all-time highs. The Federal Reserve chairman Alan Greenspan coined the term “irrational exuberance” during the run-up. However, crowd complacency enabled leverage and overvaluations to soar to unprecedented heights until the bubble burst.

During the 2008 real estate bubble, the alarming surge of adjustable-rate mortgages (ARMs) and no income no job application (NINJA) loans being sold to subprime borrowers was ignored again due to public complacency. The securitization of these subprime mortgages into collateral debt obligations (CDOs) to meet the feeding frenzy from pension funds, insurance companies, banks and institutional investors fueled another unprecedented real estate and market spike preceding the bubble burst. If the markets are surging then it must not be a big deal, right? No need to worry.

Unprecedented Central Bank Intervention

While the recent market volatility has unprecedented characteristics in terms of velocity and magnitude, the most unprecedented factor leading up to this 2020 black swan has been the intervention of global central banks. The rounds of quantitative easing (QE) implemented by global central banks since the last recession has ballooned balance sheets expanding global money supply by over $10 trillion. This asset inflation has expanded a credit bubble that has kept zombie companies and even nations alive to kick the can further down the road. The consequences of the unprecedented artificial intervention to buffer global financial and credit markets may be on the verge of unraveling.

Developing Antibodies

Much like a virus outbreak, infected persons recover with time and medication, as their immune systems develop antibodies to defend against relapse. The millennium’s prior two black swans triggered financial bear markets that preceded recessions. The recovery process included regulatory (IE: bank stress tests, increased reserves), legislative (IE: banking reforms, ACA) and monetary policy adjustments (IE: QE and ZIRP) which enabled markets to stabilize and readjust valuations. The healing process simultaneously develops antibodies to protect against future relapses as markets surpass recovery and move into accelerated growth as markets flourish to all-time highs. This has been the template for the 2001 Internet Bubble and 2008 Financial Meltdown.

The Explainable Narrative Afterwards

The final component of black swans are the deceptively obvious explanations of why they occurred, after the fact. At this point, transparency is widespread as the mainstream starts to understand the reasons as templates are created. However, this can also start to induce complacency with time as markets recover then flourish to new highs. This process has repeat itself twice leading up to the coronavirus black swan triggering financial markets meltdown commencing at the end of February 2020. The unprecedented nature of complete economic stops, not slowdowns, like in Italy and Spain to slow the spread of coronavirus is in and of itself an outlier. Central banks are desperately pulling out the proverbial bazookas to prevent credit markets from freezing up like in 2008. On March 15, 2020, the U.S. Federal Reserve initiated another emergency rate cut slashing benchmark interest rates to zero and signaled quantitative easing round four (QE4) with a $700 billion bond-buying program. Goldman Sachs suggested a potential drop on the S&P 500 to 2,000 before a V-shaped recovery back towards the 3,200 end-of-year target.