A few weeks into the New Year, investors seem to be in a
carefree mood. The traditional measures of volatility remain at
extremely low levels. After all, the European economic crisis has
calmed, budget negotiations in Washington aren't front page news at
the moment, andearnings season is unfurling without much drama
Apple's (Nasdaq: AAPL)
sobering near-term outlook).
How little volatility is there in themarket ? TheVolatility
Index (VIX) , which uses options trading activity as a gauge of
investor fear, is at its lowest level in two years.
Though investors were a bit spooked in late December in the face
of the budget crisis (which temporarily spiked theVIX ), the
long-term volatility trend has been gliding lower. Simplyput ,
investors know the typical risks that can derail the market, and
they are expecting little drama in coming months.
But what about the types ofissues that investors can't see
coming? Nassim Taleb, an author focused on randomness, probability
and uncertainty, calls these unforeseen events "Black Swans." When
one of these occurs, the market can take a fairly significant
Here are four possible Black Swans that may roil the market in
Iran deepens its nuclear enrichment program and the U.S.
Theissue of Iran's nuclear ambitions has been in the news for
so long, that investors seem to have forgotten about it.
Although the U.S.-led sanctions are having a major effect on
the Iranianeconomy , there has been little movement by the
Iranian government to seek a face-saving compromise.
Iranwill be voting for a new president this summer, as
Mahmoud Ahmadinejad's term expires in August. If his
successor is a hand-picked choice of the Ayatollah Khamenei,
then global strategists may well conclude that Iran will
maintain or deepen its hard line stance. And looming military
tensions between Iran and the West would trigger the
possibility of a closure of the Strait of Hormuz, which is
the only open sea passage from the Persian Gulf to the ocean.
In such a scenario, oil prices would quickly spike much
higher, dealing a major headwind to the global economy --
The Federal Reserve shifts its footing
ChairmanBen Bernanke has wisely sought to calm the markets by
repeatedly stressing thatthe Fed won't start raising rates
until the U.S. economy shows greater vibrancy. Although the
bank is unlikely to start raising rates in 2013, the official
statements released after Fed meetings could start to shift
in tone. The current language of perpetual monetary
accommodation could eventually be replaced by language that
hints of groundwork for eventual tightening. And once
investors start to see a shift coming into focus, they may
lose their appetite forequities . In some -- but not all --
instances when the Fed has moved to boost interest rates, the
stock market has weakened.
In addition to this tightening scenario, there is always the
possibility that existing Fed policy starts to lose its
effectiveness. The Fed's variousQuantitative Easing (QE)
measures have generally helped thebond and stock markets, but
the Fed'sbalance sheet is now so stressed, that we simply
don't know how the market will respond to any interest rate
hiccups as the effects of the variousQE programs start to
Inaction on thedeficit leads to further market-rattling debt
The ticking time bomb has been unplugged for now, as House
Republicans voted to extend their timeframe for another
government shutdown deadline into the spring. The decision to
defer a showdown is ostensibly to buy more time to come to a
bipartisan agreement on a path to close the still-massive
government budget deficit. But the two sides remain so far
apart (and have identified few areas for compromise) that a
far-reaching agreement that keeps our government debt from
eventually hitting $20 trillion seems increasingly unlikely.
Even as the total amount of government spending has grown
quickly in each of the past four years, the market has moved
higher and higher. So investors have already concluded that
the rising level of government debt simply has no bearing on
the markets. Yet you can only stretch a rubber band so far,
and as long as inaction reigns, the debt load
swells higher, and the eventual moves to start paying
down our debt will have a much more draconian effect on U.S.
economic growth. It's a notion that has been seemingly
ignored until this point, but could be the "Black Swan of
China starts selling ourbonds
China's hefty ownership of U.S. bonds has been remarkably
positive to our economy, helping to keep interest rates down
and enabling us to keep issuing more debt without any real
Yet China's new leadership has given clear signs of
shifting its economy in the direction of domestic
consumption. If they're serious about stimulating domestic
demand, then they would have less incentive to pursue a
As we saw with Japan in past decades, aweak currency only
makes sense in the context of an export-led economy. Chinese
policy makers also worry aboutinflation , and one way to keep
price pressures at bay is to let your currency strengthen
(which weakens import prices).
Lastly, China surely has an eye on the U.S. budget mess,
and may eventually follow through on its threat to strongly
decrease its ownership of U.S. bonds. Without China, Uncle
Sam would be paying much higher interest rates.
Action to Take -->
By definition, the black swan that derails markets may be one
that we can't even perceive right now. These four mentioned above
are simply the ones that we already grasp. A steadily rising
market, with multi-year lows in various volatility gauges,
underscores the need to maintain a defensive posture with your
-- David Sterman
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David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.
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