The term “black swan” is one often bantered about within the investment world, however most of the time it pertains to the hypothetical risk of a low-probability-yet-high-impact event potentially decimating everything in its path with little to no warning. The official definition of a black swan reads, “An unforeseen and unpredictable event, typically one with extreme and severe consequences.”
COVID-19 is history’s newest black swan. The fatalities due to this virus are tragic and heartbreaking and will forever define this era in history books in the years to come. In the sentences immediately following those accounts, we will likely read of the collateral economic damage it caused, resulting from business and social shutdowns necessary to combat its spread. Stock charts will also tell the tale of investors who experienced crash-like price action as evidenced by the S&P 500’s fastest 35% decline ever.
So when taking all of this into account, what should investors know right now about the history of previous black swans, and what can reasonably be inferred about today’s environment from their market impacts? In looking to assess this, we have identified and reviewed what we believe to be the true market black swans dating back to the beginning of the 20 th century. We came up with six of them.
World War I and the Spanish Flu pandemic: Believe it or not, these were actually two overlapping black swans occurring over less than a four-year time frame. A series of secret and interlocking alliances thrust the entire continent of Europe into war within weeks following the assassination of Austria’s Archduke Franz Ferdinand in the summer of 1914. The U.S. entered the war in April 1917, enabling the defeat of Germany 18 months later. However, this quickly coincided with the Spanish Flu pandemic lasting until the end of 1920. That pandemic is believed to have infected approximately 500 million people globally, or almost one-third of the world population. Historical estimates of worldwide fatalities range from 20–50 million and in the U.S., 675,000 died from that virus. At their low point, stocks dropped 29% during that time frame, but after the Spanish Flu subsided at the end of 1920, equities roared throughout the upcoming decade.
The Stock Market Crash of 1929: Following one of their greatest decades ever, stocks began to wane in September of 1929 as margin rules of this time had allowed both large and small equity investors to amass huge amounts of financial leverage. When the market dropped 23% over two days in late October of that year, millions of people lost their entire net worth and then some, seeding the roots of the Great Depression soon to follow. At its lowest point in July of 1932, the S&P 500® had declined 86% from its September 1929 high.
Europe in Early World War II: Winston Churchill called this time “The Darkest Hour,” and that was no exaggeration as the early days of WWII in Europe, from the autumn of 1939 to the summer of 1940, saw civilization teeter on the brink of demise. Following the fall of France to Nazi Germany in June of 1940 and with the U.S. yet to join the war, stocks bottomed out 29% below their pre-war level. During the Battle of Britain that summer and fall, England’s Royal Air Force courageously prevented a German invasion and by the end of the following year, the U.S. had joined Allied forces to fight and ultimately defeat the Nazis.
Worst of Stagflation in 1981: Text books had previously asserted that economic stagnation and inflation were not compatible forces. However, these two phenomenon came together to tag team the U.S. economy into near ruins during the late 1970s and early 1980s. While stagflation fluctuated for a few years, it was in the spring of 1981 that it appeared to hit a fever pitch as inflation reached 13% and an imminent recession stood on the horizon. Federal Reserve Chairman Paul Volcker made the bold decision to raise the Fed Funds rate to 20% in May of that year, cracking inflation and paving the way for economic growth once he reduced rates in the months ahead. At their worst point, stocks fell 25% from April 1981 levels, however by November of 1982 the recession passed and a major secular bull market had begun.
9/11 Terrorist Attacks and Tech Stock Bust: Stocks and the U.S. economy were already on a downward trend when the horrific terrorist attacks occurred on the morning of September 11, 2001. Markets were closed for a week and when they re-opened, amid the pain and anguish inflicted from so many lost lives, a new wave of selling accelerated the downward trend. Much of this was also attributable to a bust in technology stocks, many of them still overvalued from the internet bubble peaking in early 2000. Stocks would fall 29% before reversing in strong fashion in October of 2002.
Financial Crisis and Great Recession of 2008: While stocks peaked in October of 2007, it was not until the spring of 2008 that rumblings emerged of subprime mortgages and their securitizations by Wall Street banks posing a threat to the financial system. That risk quickly became evident after the bankruptcy of Lehman Brothers in September of that year and a mass bailout program was quickly put into effect by the federal government. During the subsequent Great Recession, markets ultimately hit their lows in March of 2009, 57% below levels prior to the crisis. The Fed then instituted large scale assets purchases, also known as quantitative easing, and as the economy shifted into recovery and growth mode, stocks began a new bull market.
The chart below displays that all of these events were followed by positive 10-year returns in the S&P 500 after the black swan had been resolved. Those annual returns ranged from 7%, in the decade following the 9/11 terrorist attacks, to more than 16%, in the 10 years after the financial crisis and Great Recession. When combining all six of these black swan events, the average 10-year return of the S&P 500 following their resolution was 13%, translating into an average cumulative return of approximately 250%.
While each of these cases are distinctly unique, history does seem to infer that while black swan events are harsh and brutal in regard to their impacts on the markets and broader society, those fierce market reactions have tended to reverse themselves quickly and forcefully once the worst appears to be over.
In the case of COVID-19, there are arguments to be made as to how and why this medically induced crisis could be reconciled sooner than most other historical black swans. From an economic standpoint, these would include the massive fiscal and monetary stimulus programs passed by Congress and put forth by the Federal Reserve to help bridge businesses, families, and individuals to a future recovery. In addition, this monetary and fiscal stimulus will likely stay in place after a recovery has taken effect, potentially acting as a further tailwind at that time.
From the medical side, improving trends pertaining to the rate of infections and fatalities as well as potential therapeutic advances in treating the virus could also move the crisis toward an ultimate resolution. So while none of these potential paths forward will be completely effective in isolation, in tandem they all help to improve the probability of an economic recovery being in motion by the end of 2020 or early 2021. Such timing would likely be quite favorably received by the markets.
This would also be historically consistent with previous black swans where history seems to infer, even during the darkest of hours, it typically pays to wait for the light.
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