Black swan events in the financial markets are terrifying. By definition they’re extremely rare and extremely difficult to predict. Which wouldn’t be so scary if their effects weren’t so catastrophic.
A 10% drop in the Standard & Poor’s 500 would certainly be painful–but it doesn’t rise to the category of a black swan. Neither does a 15% drop in the price of Bitcoins. Or a 20% drop in the price of Apple (AAPL).
All these are relatively normal negatie events. They’ve happened before. They happen relatively frequently. And in some cases–that of Bitcoin or the S&P 500, for example–they’re absolutely statistically normal for the market or a part of the market or a specific asset.
No, the label “black swan’ is reserved for things like the 2008 global financial crisis that almost brought the world’s financial markets and its real economies to their knees. Or the Dot.com crash of 2000, which saw corporate giants such as Nortel Networks disappear from the economic landscape. Or the oil price crash of 2008 that saw oil soar to a high of $147 a barrel in July and then plunge to $32 by December.
Given how devastating to a portfolio a black swan event can be, it seems, at first, surprising that most lists of “bad things that could happen in the year ahead” pretty much ignore this type of financial event. Looking ahead to 2018, it’s relatively easy to find potential lists of events such as the possibility of a fourth interest rate increase from the Federal Reserve, or a January/February shut down of the government, or a slide in the U.S. dollar. Those events are potential and they certainly may not come true, but they have relatively high odds of coming true. Say 25% in the case of an extra Federal Reserve interest rate increase. And we have reasonable tools for dealing with the consequences of these “bad events.” To stick with this example, if the Fed raises interest rates more frequently than the market now expects, investors can buy bank stocks (since bank stocks do well when the yield curve gets steeper as it usually does the the Federal Reserve is in a rate hiking mode.) We can short Treasuries either directly or through an ETF. We can bet that more vigorous than expected Fed action will slow the economy as a whole and short the Standard & Poor’s 500.
And we can do most of those things relatively late, close to the event itself, after we’ve collected more evidence. That ability to wait and see also takes a good deal out of the risk of putting one of these protective strategies to work. We don’t need to short Treasuries, for example, until we’ve seen the Fed in an aggressive interest rate raising mood, say, twice in 2018.
Possible black swans events show up infrequently on lists that look ahead to possible bad things in 2018 because they’re hard to predict, rate–and figuring out what to do about them is really, really hard. I can think of lots of ways to hedge against a big market catastrophe–that’s not the problem. But I can’t think of a lot of hedges that won’t cost me an arm (if not an arm and a leg) if I put them on and then the rarely sighted black swan doesn’t put in an appearance. This is, in my experience, why more black swans don’t show up on end of the year forecasts of potential bad events. It’s unlikely that the Chinese financial system will blow up in 2018–unlikely but not impossible. But if you think it is a possibility–at say a 1% chance–what do you do? Buying put options on an emerging market index or on the Shanghai stock market or on a big Chinese momentum stock such as Alibaba (BABA) would pay off if the Chinese banking system did indeed go into crisis. But if it didn’t–if your black swan didn’t come sailing in–your put options would expire worthless and you’d be out of pocket everything you’d spent on insurance.
I don’t have a general solution to that problem–but there is at least one black swan on the horizon in 2018 where betting on the appearance of this black swan in 2018 would be very profitable AND where the cost of protecting against the black swan is so low that putting the insurance in place is just about a no brainer. The hedge on this black swan is likely to pay off–to put money in your pocket–even if the black swan never puts in an appearance.
What is this black swan? It’s the chance–I’d say something like a 5%-10% chance–that war will break out in the Middle East between the major oil powers of Saudi Arabia and Iran. Such a war would suck in other oil producers in the Gulf and would be likely to include Iraq. The resulting conflagration would send oil prices spiking well above current projections for $60 to $65 a barrel for U.S. West Texas Intermediate at the end of 2018.
Let’s start by looking at reason for putting this black swan on the calendar in 2018.
Saudi Arabia is the crux of this black swan.
First, the kingdom is under intense stress from low oil prices and OPEC’s plan to cut production in order to clear the market of surplus oil. That has pushed the Saudi government budget deep into the red–which is a huge political issue since the deal that keeps the current royal family in power (and rolling in wealth) is built on big subsidies to Saudi citizens on everything from wages to education to food. Cutting these payments increases the risk of domestic unrest–and the House of Saud knows this.
Second, Saudi Arabia is under intense international pressure–or at least the Saudi government and royal family seems to feel that way. The country is locked in an intense battle with Iran for regional clout–and it has been losing. A proxy war in Yemen is going very badly. Iranian influence in Iraq continues to climb. The Syrian civil war looks like it will end in victory for Iran, Iranian-affiliated militias and Russia. From a Saudi point of view it looks like the Trump administration is an unreliable partner determined to fritter way U.S. influence in the region. (It doesn’t help put a positive spin on the Saudi attitude toward the United States that from Saudi Arabia’s perspective it’s soaring U.S. oil shale production that has depressed global oil prices.)
A good part of the initial motivation for the proxy war in Yemen was to demonstrate Saudi strength in the region. That it has done exactly the opposite doesn’t mean that the Saudis won’t double down: I’m sure that to some in the Saudi government and royal family it looks like the best way to restore Saudi prestige is by expanding military operations beyond Yemen. And frankly, again from a Saudi perspective, there’s no military theatre more tempting than Iran.
This doesn’t mean that an attack on Iran–probably targeting the country’s nuclear research facilities–is a given. It would be a high risk strategy and there’s no guarantee of a quick victory. A long-drawn out conflict that included Iranian-sponsored terrorist attacks on Saudi (and U.S. targets) would be a political disaster for the Saudi royal family. At the moment, I’d say, that most of the government in the country recognizes these dangers. That’s why the odds of this black swan are so low.
But that doesn’t mean Riyadh couldn’t be pushed into pursuing this strategy. Further humiliation in Yemen and further missile attacks on Riyadh would add to the pressure to act. And so could urging by the Trump administration. If President Donald Trump is intent on dismantling the Iranian nuclear deal struck by the Obama administration, he will certainly include a military option in his thinking. There’s certainly enough saber-rattling going on in Washington. For example, CIA director Mike Pompeo, an outspoken critic of Iran and the Iran deal when he was a member of Congress, sent a note to General Qassem Soleimani, leader of the Islamic Revolutionary Guard in Iran, that in essence threatened military action if Iran attacked U.S. interests in Iraq. Pompeo deserves watching as a leading indicator that the odds of this black swan are rising. If, as was rumored earlier in 2017, Pompeo replaces Rex Tillerson as Secretary of State, I’d move the odds of a Saudi military move in the region up to 20% because I’m sure that the United States would be cheering Riyadh on from the sidelines.
You don’t need any imagination at all to project the huge spike in oil prices that would follow on war in the Persian Gulf and attacks on the oil infrastructure of Iran and Saudi Arabia (and its Persian Gulf allies.) A return to the days of $100 a barrel oil would be a real possibility.
So how do you hedge–or profit from–this still low probability potential event?
You could buy futures or call options on oil itself, betting on a rise in the price of oil before the options expired worthless. That has the disadvantage of possibly generating big losses if the black swan doesn’t come sailing in at all–or doesn’t come sailing in on schedule.
My preference instead would be to buy the shares–or better yet longer-dated call options–on U.S. oil shale producers, such as Pioneer Natural Resources (PXD), RSP Permian (RSPP) or Diamondback Energy (FANG). These are all producers with big positions in the low-cost, high-growth Permian Basin. If the black swan does come sailing along, oil prices will spike and these companies, which already have plans to increase production, should see their shares soar. If, on the other hand, the black swan doesn’t make an appearance, these stocks are likely to gain anyway as these companies expand production and increase drilling under the price umbrella created by OPEC’s production cuts. I’ll be adding one or more options play on these stocks to my Volatility Portfolio early in 2018.
So that’s how I’d deal with the risk/reward/hedging cost of this black swan.
Now if I could just figure out a way to deal with the other black swans sailing the waters as we head into 2018.