The Black Swan

Forget about the Chinese stock market bubble, the US housing crisis or waning corporate profits, the real danger is the black swan

Markets will never spot the black swan

Dangers such as tension over Iran and a flagging US economy are being ignored

Larry Elliott, economics editor
Monday April 30, 2007
The Guardian

These are curious times. In the middle of last week, the Dow Jones Industrial Average (DJIA) powered through the 13,000 level for the first time. At just about the same time, the dollar's value against a basket of global currencies was at its lowest since the demise of the Bretton Woods fixed exchange system.

In the UK, the Bank of England expressed concern about the increased risk-taking in the City and the exposure of heavily borrowed private equity groups, in the week that a titanic struggle began for control of the Dutch bank ABN Amro. The Royal Bank of Scotland, in cahoots with its Belgian and Spanish partners, is mounting a £49bn hostile bid for ABN to prevent it falling into the hands of Barclays. That's an awful lot of money to pay for any company, although not quite as much as AOL agreed to pay for Time Warner in January 2000.

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In retrospect, the Time Warner/AOL hook-up was seen as the moment the boom of the late 1990s over-reached itself. It was, according to those with 20-20 hindsight, a moment of hubris. Anybody with a brain in their head could see that the only way for the stock market at the turn of the millennium was down. The intriguing question now is whether the battle for ABN marks a similar high watermark for the current boom. As the Bank noted in its Financial Stability review, the reward for taking on risk is currently at very low levels, for the simple reason that investors perceive little risk. "That has increased the vulnerability of the system as a whole to an abrupt change in conditions," the Bank said.

So what could go wrong? Certainly, the macro-economic backdrop is less favourable than it was. Interest rates are going up across the world - in China, New Zealand, Britain and the Eurozone. In the US they are on hold and are unlikely to come down until later in the year. Japan, where there were renewed signs of deflation last week, is the exception. Near-zero borrowing costs in Tokyo are the source of global speculation since they allow investors to borrow cheaply in yen and take punts in countries where interest rates are higher.

It's not just that, though. The American economy is slowing, as the GDP figures released on Friday clearly showed. A fall in the value of the dollar, while necessary to reduce the US trade deficit, will add to imported inflation, already rising as a result of higher Chinese prices and oil at close to $70 a barrel.

Nor does the geopolitical situation look that clever. Kofi Annan was in Berlin last week to lambast the laggards of the G8 for their failure to keep promises made to Africa at Gleneagles two years ago. What went unnoticed was Annan's view that a broadening of the Middle East conflict to Iran risked sending oil prices to $120 a barrel. Despite its travails in Iraq, the Bush administration is still taking a hawkish stance over Iran's nuclear ambitions; military action - air strikes rather than an invasion - is still an option.

And yet the stock markets float serenely upwards, as if they had not a care in the world. The great and the good of the financial markets have a rationale for this, which goes as follows. Share prices are high because corporate profitability is high. Corporate profitability is high because the global economy is growing rapidly, with demand more evenly spread around the continents than it was three or four years ago. There may be risks out there, but these risks are both discernible and quantifiable. The chances of a serious market disruption are, therefore, extremely slim and the likelihood is that stock markets will ride out any short-term problems caused by a touch more inflation or slightly tighter monetary policy.

This is a comforting analysis. It may also be hugely complacent. Nassim Nicholas Taleb certainly thinks so. His new book, the Black Swan, is a fascinating study of how we are regularly taken for suckers by the unexpected. Why Black Swan? Well, apparently, before the discovery of Australia it was assumed that all swans were white because nobody had ever seen one of a different shade. It took only the sight of one black swan to disprove a theory based on millions of previous observations.

Taleb argues that there are three attributes of a Black Swan. The first is that they lie outside the realm of regular expectations, with nothing that has happened in the past able to point to its possibility. The second is that they have a huge impact. The third is that despite being unforeseeable, human nature means we construct convincing explanations for the appearance of a Black Swan once it has happened.

Markets tend to work on the basis that Black Swans either don't exist or appear with such irregularity that they are not worth worrying about. As a result, traders in the City of London went home on the night of August 3 1914 seemingly oblivious to the fact that a world war lasting more than four years would start the next day. Similarly, there was not the slightest suggestion on Friday October 16 1987 that the Dow Jones would lose more than 20% of its value the next Monday. The Nobel prize-winners Robert Merton and Myron Scholes, who put together Long Term Capital Management and convinced their investors that their models made it a sure-fire bet, had failed to factor in the possibility of a Black Swan - in the case of LTCM, the Russian debt default in August 1998.

Taleb is a fan of the Polish-born French mathematician Benoit Mandelbrot, who gives short shrift to those who believe financial markets resemble a bell curve, with modest movements the norm and violent moves infinitesimally rare. Looking at the daily movements of the DJIA from 1916 to 2003, Mandelbrot said that according to the neat bell curve analysis, there should have been 58 days when the Dow moved more than 3.4%, when in fact there were 1,001.

Instead of just six days when there were movements of more than 4.5% there were 366. Only once in every 300,000 years should there have been a day when the Dow moved by 7% or more, but it happened 48 times. "Extreme price swings are the norm in financial markets - not aberrations that can be ignored. Price movements do not follow the well-mannered bell curve assumed by modern finance; they follow a more violent curve that makes an investor's ride much bumpier," Mandelbrot says in his book The (Mis)Behaviour of Markets (Profile Books). "A sound trading strategy would build this cold, hard fact into its foundations".

At the moment, it seems highly unlikely that this "cold, hard fact" has been built into market thinking, where the abiding sense is that this is forever summer. That, of course, is precisely Taleb's point. If Captain Smith knew the iceberg was there, he would have avoided it. If I knew what the next Black Swan was and when it was going to glide into view, I wouldn't be doing this job. If a Black Swan was predictable it wouldn't be a Black Swan, but the fact that markets can see only white swans suggests that the shock - if it comes - could be profound.

· The Black Swan, £20, is published by Allen Lane