Stock Market Secrets: What is normal risk?
They are calling the coronavirus a “Grey Swan” event. Not sure quite what they mean by that. Not a Black Swan event but not a White Swan event by the sounds of it. Or maybe its just an expression to say “Panic but don’t panic”.
The expression "Black Swan event" comes from 16th century Europe and relates to the saying "a rare bird in the lands and very much like a black swan". It was a phrase that described the impossible. All swans were considered to be white with the phrase "Black Swan" epitomising impossibility. Until, of course, the Dutch discovered them in Western Australia in 1697 and the phrase changed from meaning impossible to meaning the impossible can happen.
Black Swan events are events that “illustrate the limits of theory, the bounds of prediction and the fallibility of assumption”, events that come as a surprise, have a major impact or consequence and are only rationalised with the benefit of hindsight. They are rare, beyond the realm of expectation and therefore not predictable nor predicted.
Christopher Columbus coming ashore was a Black Swan event for the indigenous population of the United States, completely incalculable, unpredictable and of major impact. The attacks of 9/11 were a classic Black Swan event. The planes literally "came out a clear blue sky". The sub-prime mortgage collapse was a Black Swan event. Abnormal, not regular, unpredictable (although some obviously did - see The Big Short).
But let’s dump the explanations for a moment and tell you what “Black Swan” really means. It means “Its not my fault”. When an economist says it means “Its not my fault I can’t predict anything that you can’t extrapolate from numbers on an Excel spreadsheet”. When a broker says it it means “Its not my fault the whole market fell over and all my ideas lost you money” and when a commentator says it it means “Its not my fault my many regular predictions didn’t include this one”.
The markets are erratic and changeable, we all know that, but within that there is “normal risk” and “abnormal risk” and Black Swan events represent “abnormal risk”. Risk that is not normal. Which begs the question. What is normal?
HERES NORMAL FOR THE STOCK MARKET
- Normal is the stock market going up for three months on the trot and going down for one. ‘Normal risk’ is the stock market going down for three months on the trot. It happens. Its normal. Its not the end of the earth and most of you can happily ignore those moments.
- Normal is the stock market going up 5.7% a year. ‘Normal stock market risk’ is that it doesn’t do that. ‘Normal risk’ is the stock market having a 20% correction every three years and short of being so smart that you can time the tops and bottoms, the only way to guard against the regular corrections, especially if you are not that vigilant or engaged, is to ignore them, but above all, expect them, and ‘budget’ for them, so they don’t upset you. They are normal.
- Normal is a stock quietly trending higher or lower depending on the big drivers in their industry. ‘Normal risk’ is when something company-specific happens that defies the industry trend, like CIMIC having a big write-down against its Middle East business, or Downer EDI telling us renewable energy projects are on a ‘go-slow’ because they have a problem connecting to the grid, or Nearmap telling us they had lost big customers in the USA. On a stock specific level normal risk is specific risks and the only way to guard against them is not to hold too much of one stock, because unpredictable things regularly happen in individual stocks.
- Normal is a company meeting its forecasts on the day of its results and, if it is really clever, slightly beating expectations because they were a bit conservative with their guidance. Normal is a set of results that slightly pleases. ‘Normal risk’ is, these days, the chance that the company hasn’t provided conservative or correct guidance causing the stock to move anywhere between plus or minus 20% on results day. That, I’m afraid, is normal these days. If happiness is expectations met then if you want to be happy expect one or two ‘bombs’ every results season and break out the Champagne if you don’t get any.
- Normal is being able to rely on a 4.5% yield from the stock market plus franking. ‘Normal risk’ is when a big dividend-paying company like the banks, surprisingly cut their dividends. Its always a risk. Again, celebrate when it doesn’t happen, because it can.
The bottom line is that the stock market is riddled with normal risk and if you expect it it won’t upset you.
There is no definition for a stock market Black Swan event but let’s suggest it is something that doesn’t fit the definition of normal risk above. Black Swan events are when something abnormal happens. Something bad.
Coronavirus? Grey Swan probably fits the bill. It could be a Black Swan but more likely, at worst, its going to fit in the definition of normal risk. It might, might, be the catalyst for a ‘normal’ 20% correction, it might be the sentiment event that knocks a roaring all-time high stock market off its perch with its overbought index and its big stocks on record PEs, but “Black Swan?”. Unlikely. And anyway, Black Swan events are only identifiable in hindsight.
So I wouldn’t worry too much. And if I’m wrong….”It wasn’t my fault”.