The coronavirus is being heralded as a “black swan event” that could shake the global economy to its core. But we should have – and could have – been prepared.
Black swan events were first proposed immediately prior to the global financial crisis by former Wall Street trader and author Nassim Nicholas Taleb. They have three characteristics: the event lies outside the realm of regular expectations (unpredictable, ex. 9/11); the event has an extreme impact; and the event is rationalized as being predictable in hindsight.
Since Mr Taleb coined the term, it has been diluted to encompass things that might happen but probably won’t (“grey swans”), things that definitely will happen (“white swans”), and climate risk (“green swans”).
The coronavirus outbreak is being heralded by many outlets and organizations as a black swan. It certainly arrives at a bad time; everybody was just beginning to relax about the possibility of a hard Brexit, a shooting war in the Middle East, and the possible impeachment of President Donald Trump. And while its long-term impacts are still unknown, it could easily kneecap the Chinese economy at a time when it’s the main driver of global growth.
But it doesn’t quite fit the bill, because it breaks that first rule: a pandemic impacting the global economy was not a matter of if, but when (not totally unpredictable in foresight). And while this might sound like a rationalization of the event as predictable in hindsight, it’s not.
Global pandemics aren’t an outlier, and neither are their effects. Even when the primary means of trade and travel was tall ship, the spread of deadly viruses was a significant threat. The Black Plague killed over a hundred million people – and while everybody has started washing their hands a lot more since then, the threat (and chance) of a global pandemic has only grown as intercontinental travel time has collapsed down to the length of days, if not hours.
“If it is true to say ‘what’s past is prologue’, then there is a very real threat of a rapidly moving, highly lethal pandemic of a respiratory pathogen killing 50 to 80 million people and wiping out nearly 5 per cent of the world’s economy,” the World Health Organization wrote in its Global Preparedness Report in 2019.
“The world is not prepared.”
And while the coronavirus is yet to wipe out 50 to 80 million people – it hasn’t quite hit 1,000 yet – the economic damage is already severe. It’s hard to believe that the modern, interconnected world is vulnerable to something that has been killing people since before we were walking around on two legs. But the fact that markets have been caught off-guard only reflects complacency, not unpredictability.
Nassim Nicholas Taleb in his book, “The Black Swan: The Impact of the Highly Improbable” predicted the 2008 financial crisis and the world pandemic anytime (not a question of if, but when).
How do we approach this Gray Rhino Market?
The SPY, the ETF (exchange traded fund) representing the major index S&P 500 (a basket of 500 stocks of healthy American companies) reached the bottom 228.02 on March 18, 2020, intraday, that took out the low of 233.76 reached on Christmas Eve of 2018. That looks like the bottom for now. The Russell 2000 (RUT) reached an intraday low of 966.22 on March 18, 2020, which is far worse than 1266.92, the previous low on the Christmas Eve of 2018. RUT comprises small caps stocks such as banks that were hit with liquidity problems which is the main reason for that.
Before talking about the recovery process, the reasons causing such a drawback (thanks to John Carter, the author of “Mastering the Trade”) in these indices are due to imploding volatility funds, lack of liquidity and the fear of coronavirus that induces uncertainty. Wall Street does not like uncertainty. The large hedge funds such as Bridgewater Capital and Citadel will not be able to sell their securities due to high volatility in the prices that causes liquidity problem, meaning lack of cash to buy securities at lower prices. When they finally sell to get out of a massive position the prices drop further. These funds are waiting to implode so we never know the real bottom. However, they can borrow funds from banks at almost zero percent interest and start buying at fire-sale prices to push the market up. That is the purpose of the quantitative easing by the feds up to $1.5T. So when the demand exceeds the supply, meaning the buyers exceed the sellers, is when the slope of the equity curve hits zero, and turn around happens. There are Algos (algorithms) employed by traders like Goldman Sachs that cause additional problems of selling without reasons, based on programs that may not be applicable for the current situation. On top of these, we have the options, Bond, Forex and future markets which bring enormous leverage in to the picture not suitable for average Joes and Janes. The US dollar is in demand and that pushes the Euro, Gold, Bond yield and the British Pound lower. We can trade this opportunity in the options market (UUP, FXE, GLD, TLT and so on). However cash is the king, if you have it, that is.
The current gray-rhino drawdown happened over 17 weeks as opposed to 17 months during the sub-prime melt down of 2008. That shows the severity of this collapse.
The recovery is most likely to be “W” recovery. This means the market will recover and reverse to test the bottom once again before taking off fully. The reason for this is profit-taking which amplifies volatility. So we have to keep watching that.
If you want to play with TVIX ETN (exchange traded note), which mirrors the VIX (CBOE volatility index for S&P 500), one can buy and sell UVXY which is affordable and optionable. These will move fast or sit there for months and so may not be suitable for average Joe & Jane.
So under the current known-unknown, gray rhino situation the best way to play, the absolute bottom is to use an option to sell a put option and collect premium, now that the premiums are elevated due to volatility. I used this yesterday on airline stocks that are beaten down by as much as 70%. UAL, DAL, TBLU (united airlines, Delta, Jet Blue). Keeping the minimum sizing, say 1 contract that controls 100 shares, sell the put with expiration of April 17, 2020 or beyond, at the bottom strike price of $15 for DAL and collect $325 premium. Two things will happen at expiration: if the stock price is greater than $15 you get to keep the entire $325 less commission, which is free money (1200% return annualized); if it goes below $15 you are obligated to buy 100 shares at $15 each for $1500; this isn’t bad because that is a bottom-price you wanted anyway! That is Warren Buffett”s and other pros’ strategy. If the stock moves up so far up we can close the position by buying back the put option for pennies before expiration and keep the net premium collected upfront. This is not very difficult to do. All my position on the airline puts are up by 30% in one day already. We can do this for all the stocks such as UTX, LOW, IWM, SPY and so on even in an IRA account! But you have to have the cash to cover it.
Always remember investing and trading is a zero sum game. If you win someone on the other side is losing.
Finally, it is a very good idea to write a book about these practical way of playing the market under any circumstances.