Investors spend so much time thinking about the probable that they rarely contemplate the outsized impact of the unlikely. We pore over financial statements, dive deep into economic indicators, and try to assess the result of acquisitions, trade agreements, management changes, and political shifts, but the black swan can fly right past our faces and tear all this careful analysis to shreds. Because it's nearly impossible to predict, the emergence of a black swan -- that rare and unlikely event that changes so much of our world that it can often only be understood in hindsight -- is typically ignored despite the simple fact that such events can do more to our investments than years of steady progress.
As we approach the new year, we confront a world whose future is as unknowable as ever. We may never know whether catastrophe is just around the corner, but what we can do is try to understand the shapes it might take so that we can better prepare ourselves for the impact. And let's not forget that a black swan can, from time to time, lay a golden egg.
Natural disaster: nature's black swan
No one can deny that an enormous number of people live in hurricane-prone regions around the globe, and it's clear that monster storms can strike almost anywhere in the world's most populous coastal regions -- New Orleans and New York have both been ravaged by punishing hurricanes over the past decade, and both India and the Philippines encountered monster storms in just the past two months. Add in the threat of a major earthquake -- one measuring 7.3 on the Richter scale struck off the coast of Japan less than a month ago -- and you have a double whammy of coastal destruction just waiting to damage places inhabited by millions.
Drought and forest fires also present challenges to inland populations, and the remote possibility of a damaging asteroid strike -- the likelihood of which was recently upgraded by an order of magnitude following an airborne blast in Siberia last year -- could threaten any place on the planet. All of these events have actually happened in recent memory, and the historical record is full of evidence that a wide range of natural disasters can and will hit vulnerable populations without much warning. Other major natural threats include the emergence of a new pandemic disease, a large volcanic eruption, and a huge snowstorm. These three types of disasters have all hit the United States in the past century.
But here's the thing: Unless you've lived for a century, none of the world's most damaging natural disasters have happened in your lifetime. The Spanish flu outbreak of 1918 killed millions, but the Dow Jones Industrial Average (DJINDICES:^DJI) actually grew strongly throughout the pandemic period. Modern medicine didn't exist at the time, and its emergence is the reason why no comparable outbreak has taken place since. The 1906 San Francisco earthquake ruined the city and helped deepen an economic downturn, but it was hardly the only contributing factor. However, that earthquake also led to the development of stricter building standards, which makes it far less likely that threatened areas will suffer similarly devastating aftereffects due to shoddy construction. Hurricane Katrina caused over $100 billion in damage, but couldn't slow down a bull market that continued for two more years.
The perfect storm could certainly come along and wallop New York City with enough fury to disrupt market activities, but this alone isn't reason to fear a crash. It would take an unprecedented and completely unanticipated disaster to significantly alter the course of the modern economy. That's possible, but highly unlikely, given the multitude of tracking and modeling options available.
Likelihood in 2014: Moderate
Impact: Low to moderate
Financial disaster: Wall Street's black swan
What do the collapse of Lehman Brothers and the Crash of 1929 have in common? Both events took market-watchers by surprise and accelerated two of the worst declines the Dow has ever seen. Both were caused by failures of regulation -- the former case saw Lehman leverage up 30-to-1, and in 1929 even ordinary investors could be operating with 10-to-1 leverage -- and resulted in extreme declines across the market as overextended investors fell underwater on their investments and faced margin calls they couldn't meet. But what's also notable is how far apart the two events were. Between the early years of the Great Depression and the crash of 2008 there were no major financial crises that were not effectively handled by government regulators (the savings and loan meltdown, while damaging to the banking sector, did not significantly impact the rest of the economy).
The most remarkable thing about the modern American financial system is just how rare these earth-shaking events have become. Prior to the New Deal's banking reforms, financial crises hit the U.S. so regularly that depressions and financial crises became nearly synonymous. The panics and resultant depressions of 1837, 1857, 1873, 1893, and 1907 were all driven by a largely unregulated financial system that overextended itself on speculative projects. But after the Great Depression, it took nearly eight decades -- and a lot of deregulatory efforts along the way -- to see a true financial panic again.
The risk of another Lehman is real, but it looms less prominently today than it did during the last decade, when a long-running real-estate frenzy tipped a number of market-watchers off to some impending catastrophe. Before Lehman collapsed, the American financial system had already been backstopped by hundreds of billions of dollars' worth of government support. After Lehman, no one could be sure whether the government would be able to support other teetering banks, and that changed the tone on Wall Street as the Dow plunged to new depths.
Financial regulations appear still to be inadequate to cope with the growing size and complexity of the American financial system, and the post-crisis formation of several megabanks also increases the systemic risk in a highly interconnected system. The black swan of financial disaster is easier to see than most, but its threat often lies more in the political response than in the event itself. Thus far, the response has been sorely lacking.
Likelihood in 2014: Low to moderate
Impact: Very high
Political disaster: humankind's black swan
Congress is more polarized than it's ever been. Approval ratings for much of Washington are at or near all-time lows. Over the past two years we've gone through multiple games of chicken over the debt ceiling, which, as far as political grandstanding goes, is not unlike playing catch with a nuclear bomb in terms of its danger to the global economy. These attention-grabbing stunts are only one way in which political malfeasance can upend our lives; the threat of war, the deregulation of dangerous industries, the over-regulation of promising industries, and the misapplication of government funds to foolish projects all carry varying levels of risk to the economy and society at large. Let's face it -- bad politics makes for dangerous times.
The problem with predicting the will of the people, or the will of those governing them, is that it's simply impossible to fit a human being into a box that says "Rational Outcomes Only." We're not rational. We're prone to manias, depressions, petty vendettas, boiling rages, sensible compromise, and complete inflexibility, and we might go through the whole gamut of emotions in far less time than it takes to elect a new congressman. We're so easily led astray that millions of us often vote against our own best interests when these politicians tell us what we want to hear.
Political black swans can rise up nearly without warning. A single poorly considered vote on an important bill can have devastating consequences for an entire country, and an election that sweeps in extremist parties can (and often does) change the course of history in unexpected ways. The risk of extremist politics is heightened during times of economic distress, as public frustrations with the status quo can be more easily inflamed. History offers a number of examples of bad political decisions causing lasting economic harm. World War I was economically devastating for Europe. Hoover's fumbling exacerbated the Great Depression. Johnson's decision to escalate Vietnam produced widespread unrest, and Nixon's efforts to restart the economy led to a decade of stagflation. Deregulation in the 1980s and 1990s resulted in a more fragile financial system, and two poorly conceived wars ran up a huge tab on America's credit card.
Unfortunately, there is often little to be done about this problem between elections, so at best, all we can usually hope for is a government that works after we've voted it in. If that doesn't happen, then political tussles can easily unleash multiple black swans in the course of a single electoral cycle.
Likelihood in 2014: High
Level of stupidity: Very high
Energy breakthrough: the Earth's black swan
For the first few years of its existence, the entire oil industry was essentially confined to a small patch of land in western Pennsylvania. Fears of an end to the flow of oil were a part of the industry almost from its inception, and although drillers struck oil in California two decades after the first Pennsylvania gushers, it would take decades more before the industry shifted away from Pennsylvania and toward oil-rich states like Texas. Even though multiple gushers eventually coated the landscape with black gold throughout the late 19th and early 20th centuries, the fear of "peak oil" never fully subsided.
This constant background fear has driven the resource-exploration industry to some pretty incredible feats, from deepwater drilling rigs that can seek out oil 20,000 feet or more beneath the surface of the ocean to new hydraulic fracturing techniques that have set American oil production figures on an upward trajectory for the first time since the early 1980s. Such developments are not frequent -- there's no indication that substantial domestic oil reserves remain undiscovered -- but when they do occur, they can have a tremendous impact on the global economy. This impact often takes years to be fully felt, which makes it more difficult to anticipate the full effect of a major new resource breakthrough.
Likelihood in 2014: Low
Impact: Moderate to high
Technology breakthrough: innovation's black swan
The steam engine, dynamite, aluminum, the automobile, the radio, the aircraft, the transistor, the satellite. The story of the economy is ultimately the story of the technologies that drive it forward, and it's rare that the people who develop the most notable new technologies can come close to grasping the enormity of the changes they set in motion.
People understood that cars would replace horses, but they didn't anticipate the way the automobile would change everything in our lives; everything from the rise of suburbia and the shopping mall to the creation of petro-states in the Middle East is a result of our national car culture. People understood that computers were going to be incredibly useful as calculating tools, but it's doubtful that anyone who worked on ENIAC expected something millions of times more powerful to fit in the palm of your hand -- or that it would be used primarily to post pictures of yourself to social websites in between rounds of Candy Crush. We often look at something that seems like a huge breakthrough and simultaneously project the growth of current technology out to the moon while failing to fully account for the ways that both the breakthrough and society will change as technology matures.
Because we're almost conditioned to expect rapid technological improvement, we investors will often fall into the trap of dubbing every breakthrough a world-changing transformation and every company that develops it a world-beating investment to hold forever. Many breakthroughs do indeed change the world, and a number of companies behind those breakthroughs go on to become phenomenal investments. But more breakthroughs are only stepping stones or dead ends, and many innovative companies eventually fizzle out to newer competition. A technological black swan could result from the maturing of existing technologies, which happened when the iPhone was released, or it could take the form of a breakthrough in quantum computing that won't be felt by the masses for years to come. Both breeds of this black swan provide excellent investment opportunities, but they can be difficult to fully appreciate until after widespread adoption.
Likelihood in 2014: Moderate to high
Impact: Very high