“The bottom line is that no compound growth can be sustained”Jeremy Grantham
Having been hit with a series of extreme events in recent years (including the financial crisis and subsequent bailout of the commercial banking industry, 50% drop in stock prices, 30% drop in housing prices, Japanese earthquake and tsunami, to name a few) many people are asking the question: “What is the next black swan?”1 The answer of course is that we don’t know what the next black swan will be. But we can be fairly confident based on past experience that there will be a “1 in 500 year” event coming along pretty soon.
Black swans are events that are perceived to be extremely unlikely to occur and yet have momentous consequences when they do occur. Author Nassim Taleb argues2 that our training and intuition lead us to ignore black swans even as we are repeatedly pummeled by their effects.
Given the substantial frequency of these extreme events it would be highly useful if we could anticipate their onset. But, they are inherently unpredictable. So, what is a coherent strategy in the face of black swans? Taleb argues that we should focus on reducing what he calls fragility or vulnerability. This can be done by reducing debt and leverage, diversifying, owning options, maintaining a substantial cash reserve. Bank regulators proposing higher capital requirements is a step in this direction.
Taleb also urges us not to attempt to forecast future events, nor to rely on someone else’s forecast. This seems reasonable to me if it means to avoid overweighting one particular scenario, the probability of which is almost surely not very high. But that does not mean that we should not attempt to think through how our strategy or position is likely to fair in a range of alternative futures. Indeed, we should do so. These alternate futures should include stress scenarios, where we identify the key risk factors relevant to our strategy or portfolio and assess worst case outcomes for these factors.
Positive Black Swans
Black swans do not have to be negative. It is certainly possible to think of extreme events that have positive consequences and we should attempt to be in a position to benefit from them. Naturally, if you are short when the market falls 50% then you have done well. The same black swan can be beneficial for some and detrimental for others. Extreme events present opportunities for extreme out performance. One example is the aftermath of a great market crash. Mean reversion often propels a major market advance, one that can be taken advantage of by investors who have cash reserves and a steady hand.
Another type of positive black swan is a major innovation that enables new products or services to be offered. This can be negative for the producers and vendors of existing products that become obsolete, but tends to be highly beneficial for producers and consumers of the new and improved products.
Economic progress over an extended period is the greatest black swan. In the past 50 years, rising productivity levels have brought billions of people out of extreme poverty into relative affluence. Today, roughly 1 in 6 people worldwide remain stuck in extreme poverty. This is a lot of people (more than 1 billion) but 50 years ago half the world’s people were still very poor. It is quite likely that the next 50 years will see most of the current poor leave that condition behind.
Some observers see this greatest of the positive black swans as leading inexorably to the worst of the negative black swans, in which rising energy demands run up against resource constraints to produce catastrophic climate change, commodity price shocks and potentially the demise of human development.
Modern Day Malthusians
The original Malthusian, Thomas Malthus, wrote in 1798 that the power of human beings to procreate was much greater than the power of the Earth to provide food and because of that “the bulk of mankind will forever live in poverty.” This story pretty well summarized economic conditions from the days of the cave man up to Malthus’ time. But it turned out to be an awful forecast for the next two hundred years. Output per person began to rise in the West around 1800 and averaged 1% per year through the 1800s, and accelerated to 2% per year in the 1900s.
Despite this productivity miracle, or in some cases perhaps because of it, there has been a steady stream of modern day Malthusians. One of these is Jeremy Grantham, Chief Investment Officer of money manager GMO. Grantham writes in his latest quarterly letter3 that the global community has reached an historic turning point. Whereas for the past 200 years the real (deflated) prices of commodities has been trending lower, he sees a turn. According to Grantham’s research, we are pushing so hard against the limits of agricultural, metal and energy resources that the long-term trends in commodities are now headed higher. After all, he notes “we can’t have compounded growth forever.”
Maybe not forever, but is there really compelling evidence that we have hit the wall? Of course today we are seeing a tremendous commodity price boom. But this is nothing new, we have seen similar booms in the past. Each one has unleashed a significant response. Through a combination of conservation, substitution, exploration and discovery, the response to prior commodity price peaks has been increases in supply and decreases in demand sufficient to drive prices lower, even lower than before the boom. As documented by Julian Simon4 and stipulated by Grantham, the result of this process over recorded history has been a continuing downtrend in commodity prices from cycle to cycle.
Grantham believes it is different this time, due primarily to much greater global economic growth as China and India industrialize. His investment advice: buy commodities on dips.
Asset Allocation
While I don’t find the Malthusian story or forecast compelling, holding a long position in commodities is probably a reasonable strategy. It provides insurance against at least one species of black swan. Following Richard Ennis in his 2009 Financial Analysts Journal article on “Parsimonious Asset Allocation,”5 the fundamental components of a coherent asset allocation framework are risk control, equity exposure and active management. Risk control can be achieved through a considerable allocation to assets which will provide a safe haven in tumultuous circumstances, assets like cash, gold, Treasury bonds, TIPS, and an assortment of long options positions.
The “safe” portfolio is the way to protect against unanticipated black swans, and to be in a position to potentially take advantage once they do occur. An alternative approach is to hold more risky assets, but only with a sell discipline. This seems to me to be a good concept in theory, but difficult to implement successfully.
Equity exposure is the second piece of the Ennis strategy. For those investors who do not feel they have special skills in stock picking, economic forecasting or manager selection, the best vehicle for equity exposure is one or more broad passively managed index funds or ETFs. For those investors who do believe they have such skills, a heavy allocation to active management is appropriate.
1 Barry Ritholtz, “Anticipating (versus reacting to) the next black swan,” Washington Post, April 2011.
2 Nassim Taleb, “Nassim Taleb on Living with Black Swans,” Interview, April 2011.
3 Jeremy Bentham, “Time to Wake up: Days of Abundant Resources and Falling Prices Are Over Forever,” GMO Quarterly Letter, April 2011.
4 Julian Simon, The Ultimate Resource 2,
5 Richard Ennis, “Parsimonious Asset Allocation,” Financial Analysts Journal, 2009.