“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
- “Black Swan” Risk Rises to the Highest Level Ever
- Black Swan Risk Also Referred to as “Tail Risk”
- “VIX Index” is Different From Black Swan or Tail Risk
- CNBC: 32% of Americans Say Economy Will Get Worse
- SPECIAL REPORT: Seven Risk Factors That Could Drive the Markets Lower
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.
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.
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:
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 basket of derivatives that will perform poorly during normal market conditions but soar when markets plunge. These include options on a variety of asset classes, such as equity indexes, credit-default-swaps, etc.
Most multinational banks sell Tail-risk products for their larger customers. Some large asset managers like BlackRock and PIMCO have made a business of advising customers on managing for the worst case. Some hedge funds have also gotten into the act.
Several “Tail funds,” which invest in assets that should rise in bad economic times, have started up since the bear market in 2008. These funds tend to lose money in years when the stock market is normal but have the potential to return 50-100% or more when the market dives. [FYI, I don’t recommend these funds.]
Generally, such Tail-risk funds are aimed at large institutional investors, not individuals. Likewise, most individual investors don’t trade based on the Black Swan (SKEW) Index. But since many of you probably hear these terms tossed around in financial circles, I thought I would try to briefly explain them today.
“VIX Index” is Different From Black Swan or Tail-Risk
The CBOE Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. If the S&P 500 volatility goes up, the VIX goes up; if volatility goes down, the VIX falls. Often referred to as the “Fear Index,” the VIX represents one measure of the market’s expectation of stock market volatility over the next 30-day period.
As you can see, the VIX shot up to its highest level since 2008 in late August when the stock markets turned extremely volatile. The CBOE SKEW Index was elevated in late August but it did not hit its record high above 151 until October 15.
Since its introduction in 1993, the VIX has been considered by many to be the world’s premier barometer of investor sentiment and market volatility. Many investors expressed interest in trading instruments related to the market’s expectation of future volatility, so VIX futures were introduced in 2004 and options were introduced in 2006.
CNBC: 32% of Americans Say Economy Will Get Worse
Earlier this month CNBC commissioned a new poll to see how Americans are feeling about the US economy. Surprisingly, optimism has declined significantly since the same poll was conducted in June. The question is why? I’ll summarize the findings for you below.
Whether it’s the recent plunge in the stock market, weaker forecasts for 3Q growth in the US or the geopolitical developments in Syria, something has taken a toll on American economic optimism recently.
The CNBC All-America Economic Survey in early October found views on the current state of the economy about stable, with 23% saying it is good or excellent and 42% percent judging it as fair. Yet about a third said the economy is poor, up 3 points from the June survey.
But the percentage of Americans who believe the economy will get worse rose 6 points to 32%, the highest level since the government shutdown in 2013. And just 22% believe the economy will get better, 2 points lower than June and the lowest level since 2008, when the nation was gripped by recession.
The decline in optimism was fueled by rising concern among some of the most upbeat demographics from previous CNBC polls. For example, the percentage of Democrats who say the economy will improve fell 7 points to just 29%. Democrats are usually more optimistic when their guy is in the White House, but apparently they are losing patience with Mr. Obama.
Among those with incomes of $100,000 or greater, optimism fell a massive 17 points to just 19%. The decline among the wealthy suggested that at least part of the rise in pessimism can be linked to the plunge in the stock market.
Also, US economic growth in the 3Q was lackluster according to most forecasters, which likely affected the change in attitudes. A weak 1Q (0.6%) was followed by a strong rebound in the 2Q (+3.9%) but that apparently didn’t carry over into the July-September period. Job growth has also slowed in recent weeks
Views on the stock market, not surprisingly, deteriorated as well. Overall, 46% of respondents said this is a bad time to invest in stocks, a 12-point gain from the June survey. Just a third of respondents said it’s a good time to invest.
As noted above, attitudes eroded among the wealthy and those with considerable sums in the stock market as well. In fact, the outlook among those making incomes of $100,000 or more fell by the most of any category, followed by retirees, as you can see below:
Real estate remained the top investment choice, picked by 39% of Americans. It has steadily gained in popularity since the depths of the recession in 2008. Stocks and gold continue to jockey for the #2 position from survey to survey.
In the latest survey, gold edged out stocks as the second-most popular investment for 25% of Americans, compared with 21% for stocks. Equities had beaten gold in the June survey. Yet the market’s move down this summer, especially the plunge in late August, has served to make investors wary.
Fortunately, there was one piece of good news in the latest CNBC survey: 40% of Americans believe their wages will rise in the next year, slightly more than in the previous survey. The average American looks for a 4% gain in wages over the next 12 months. That may be optimistic given that wages barely rose more than 2% in the last 12 months.
Gallup’s U.S. Economic Confidence Index has been trending lower since early February, reaching an 11-month low of -17 in late August, amidst the stock market sell-off and worries about China. The Index has rebounded modestly since then.
These data explain why even though the economic recovery continues, most Americans are worried about the future. We will, of course, revisit this issue in the weeks to come. As always, feel free to call us at 800-348-3601 if we can be of help in these uncertain times.
SPECIAL REPORT: Seven Risk Factors That Could Drive the Markets Lower
The stock markets plunged lower in late August and most investors are puzzled as to the reason(s) why this happened – and worry whether this pattern is a short-term bump in the road or something more serious.
Back in March and April, I saw the storm clouds gathering on the horizon and warned my readers to reduce their long-only (buy-and-hold) positions in stocks and equity funds. Still, most investors don’t understand why this six year-old bull market seems to have run off the tracks.
For this reason, I have recently completed a new Special Report: Seven Risk Factors That Could Drive the Markets Lower. In this report, I discuss in detail the unique combination of risk factors that are weighing on the markets today and why they may continue to do so.
Best of all, I offer advice on what you can do to protect yourself should the latest market downturn continue. If you are looking for some clarity in this crazy market and some advice on how to protect your portfolio, CLICK HERE to download my latest FREE SPECIAL REPORT.
As always, feel free to forward this to family and friends that you think might benefit from it.
Gary D. Halbert