“Black Swan” Risk Index Soars To A Record High by Gary D. Halbert

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
October 20, 2015

IN THIS ISSUE

  1. “Black Swan” Risk Rises to the Highest Level Ever
  2. Black Swan Risk Also Referred to as “Tail Risk”
  3. “VIX Index” is Different From Black Swan or Tail Risk
  4. CNBC: 32% of Americans Say Economy Will Get Worse
  5. SPECIAL REPORT: Seven Risk Factors That Could Drive the Markets Lower

Overview

Last week, the so-called Black Swan Index soared to a new record high, first on Monday and then another new high last Thursday, and it remains elevated today. This Index approximates the likelihood of surprise, impossible to predict, major events that can negatively affect the stock market in a big way.

Better known as the Chicago Board Options Exchange SKEW Index, this indicator is watched closely by many institutional investors and hedge fund managers. When the SKEW Index is high, as it is today, these sophisticated investors often look to hedge their downside risk in equities, fearing an unexpected negative surprise.

We’ll also look into the term “Tail-risk” and what it means for investors. Elevated Tail-risk is another indicator that surprise negative events may happen just ahead. While we’re at it, we’ll look at the CBOE Volatility Index, better known as the “VIX.” The VIX is a measure of near-term volatility in the stock market.

You frequently hear terms like Black Swan risk, Tail-risk and the VIX on financial shows like CNBC and others, but I’m not sure most investors know what they mean (many brokers and advisors probably don’t either). I’ll try to clarify them as we go along today.

Following that discussion, we’ll look at a new poll from CNBC which found that not only do one-third of Americans believe the US economy is not getting better, they actually believe it’s going to get worse just ahead. Optimism has faded in the last few months. Almost half of those polled said now is not a good time to invest in stocks. And there’s more.

“Black Swan” Risk Rises To The Highest Level Ever

A black swan (Cygnus atratus) is a large waterbird that was originally native only to southern Australia, and thus was considered very rare. While black swans – with their black feathers and extremely long necks – have been introduced to various countries over the years, mostly in zoos, they are still considered rare as opposed to their white-feathered brethren.

"Black Swan" Risk Index Soars To A Record High

In the investment field, the term “Black Swan” risk refers to a high-profile, impossible to predict, major event that negatively affects the market(s) in a big way.The term Black Swan, as it pertains to investments, was first introduced by Nicholas Taleb in his 2001 book Fooled By Randomness. The book deals with the fallibility of human knowledge and how we deal with good and bad decisions.

Since Taleb applied the Black Swan term to the financial markets, it has become a popular metaphor for unexpected negative events that occur from time to time. So much so that there is actually a so-called Black Swan Index produced by the Chicago Board Options Exchange (CBOE). Officially, it’s called the CBOE “SKEW Index.”

In simple terms, the CBOE SKEW Index measures the differences in the costs of far out-of- the-money call and put options on the S&P 500 Index. If the SKEW rises sharply as it has since late August, it means that many traders believe there is an increased chance of a significant negative surprise in stocks in the near-term.

As the CBOE itself says, the SKEW Index measures “the risk associated with an increase in the probability of outlier returns, returns two or more standard deviations below the mean [current price].”  Think stock market crash, 2008 or Black Swan.

Black Swan

On Monday of last week, the SKEW hit a new record high of 148.92. At that level the market was suggesting a roughly 15% chance of a two or more standard deviation move lower in the S&P in the next 30 days.  The SKEW hit another record high above 151 on Thursday of last week. It has since moved a bit lower but is still elevated.

The CBOE notes that until recently the SKEW’s all-time high was 146.88 in October 1998, during the Russian financial crisis, and the month when the Federal Reserve surprised many with an interest rate cut. The value of the SKEW was also high in June 1990, immediately before the July 1990 recession, and in March 2006 – a period of heightened concern about a possible bursting of the housing market bubble.

In short, when the SKEW is near 100, the perception is that there is very little risk of a wildly negative surprise (or surprises). On the other hand, when the SKEW is high, the perception is that there is high risk of a major negative surprise in the next 30 days – one that could send the S&P 500 Index down very sharply, very fast.

It’s still unclear what exactly caused the SKEW to rise to record levels last week. Stocks as measured by the S&P 500 posted a strong gain last week, but there is no shortage of uncertainty on multiple fronts right now. And, of course, October is known for market crashes like the “Black Monday” collapse 28 years ago this month. But that’s true every year, not just this year.

Black Swan Risk Also Referred to as “Tail-Risk”

Black Swan risk from unexpected, unpredictable negative surprises is also often referred to as “Tail-risk” by professional traders and hedge fund managers.

Tail- risk, like Black Swan risk, is the risk of an asset or portfolio of assets moving three or more standard deviations down or up from its current price. In particular, most asset managers are only interested in the downside risk (ie – moving three or more standard deviations below its current price).

When constructing an investment portfolio, models can be used to estimate the probabilities of likely future returns. While past performance is no guarantee of future results, most portfolio managers still like to use these models to establish a “baseline” of what might be expected. A “bell curve” is the most likely illustration.

In a normal bell curve, the most probable returns are concentrated in a bulge near the center, which is the average expected return – or the “mean” – with less probable or more extreme returns tapering away toward the edges, as you can see in the chart below:

Black Swan

Tail-risk represents the probability that the magnitude of returns on an asset or a portfolio of assets will exceed some threshold (usually three standard deviations) on the normal curve. If you visualize a normal curve on standard axes, the tail on the left side corresponds to an extreme low or negative return, and the tail on the right side corresponds to an extreme high positive return.  An analyst might look at these in order to estimate the impact of rare but significant events.

There are different ways to hedge Tail-risk, but a popular one is to create a

1, 23  - View Full Page