Most of the time, when pundits say "black swan," they really mean "a disruptive event that no one saw coming - much less had any idea how to deal with."
So they're manageable, but they can still be downright dangerous to your money. That means a broad perspective, a willingness to entertain all the possibilities, and robust asset protection strategies - like the ones I'm about to show you - go a long way in helping you avoid these events.
The best part is, you can even make some nice money while everyone else loses their shirt...
This Can Be a Very Profitable Exercise
Laying some of the groundwork for this exercise is Société Générale SA's (EPA: GLE) (SocGen) recent quarterly Global Economic Outlook.
In this report, the international French bank proposes a number of potential "black swan"-type events, and then provides some detail on their thinking about how likely these are to occur and what kinds of effects they may have on the global economy.
Interestingly, SocGen sees more downside risks than possible upside surprises. That's an outlook I'd have to agree on.
Let's look at SocGen's forecasting and analyze the risks, rewards, and possible impacts.
First, the disruptors...
No. 1. A "Brexit" (British Exit) from the European Union: 45%
From SocGen: The United Kingdom's Prime Minister Cameron is likely to hold a referendum on whether the UK should exit the European Union. That's likely to take place late next year. Expected impact: Low.
Now, the UK is part of the EU and already wields a fair degree of independence via its own pound sterling currency. With all the problems Greece has faced, it's still part of the EU. So I don't see the UK going anywhere, just negotiating a better deal. I peg the probability of a Brexit at 10%.
No. 2. A Hard Landing for China: 40%
From SocGen: Expect a 40% risk of seeing a lost decade scenario instead in the medium term. Risk of hard landing comes from credit crunch due to intensified capital outflows, bad loans, lack of central bank stimulus; failing housing demand could see developers fail, cutting development; capacity overhang means manufacturing could keep suffering, leading to bankruptcies and unemployment.
I believe China's administration realizes the magnitude of the challenge in transitioning to a consumer economy. It's likely to use its massive reserves and to stimulate through quantitative easing (QE) and lowering rates to ensure the smoothest transition possible, as not doing so carries huge risks to stability. I see the probability of a hard landing at 20%.
No. 3. The American Consumer Saves More: 25%
Hey, I guess it could happen, but with such low oil/gasoline prices, consumers are already saving more by default. I think the risk of more saving is closer to 15%. It's sad to see that SocGen considers saving more to be a negative, too.
No. 4. A New Global Recession: 10%
Here I think SocGen has totally underestimated the odds. I believe they're likely much closer to about 35%. But don't forget - there would almost certainly be a worldwide coordinated mega-QE program to combat this.
No. 5. The Fed Hikes Rates Too Late: 10%
Is SocGen kidding? It's already too late. So, I'd have to peg this at 100% probability, if that's possible. But better late than never, I guess. Anyways, a rate hike is highly likely this month, so the next issue will be the size of the hike, then follow-through with subsequent hikes, their size and frequency. Of course, Yellen's measured pace means don't expect too much too fast.
Now, it has to be said that 2016 holds the possibility of a few positive surprises, too, though not as many as we'd like. These actually have the potential to improve the global economic outlook - and line our pockets, if we're properly prepared.
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SocGen "Upside Surprise"
No. 1. Stronger Investment and Trade: 20%
I'd agree there's about a 20% probability of this, what with all the QE, ultra-low rates, and other massive stimulus that's already taken place. This would help boost economic activity somewhat.
No. 2. More Fiscal Accommodation: 15%
Again... Hah! Fiscal accommodation has never ended even, unarguably, in the United States, where rates are still abnormally low. And consumer and government debt are dangerously high, so rates have to stay low. At this point, though, the effect is probably neutral, since economic activity is still too low to encourage any significant new borrowing.
No. 3. Fast-Track Reform: 10%
This is pretty laughable, too. Structural reforms are the right thing to do, so naturally they're just about the last thing on central planners' minds. Reforms have proven effective, but also painful and politically suicidal. My take? Zero percent probability. It's not gonna happen.
How to Prepare for These Outcomes
Given all of these points and the fact that, by definition, there are black swans circling that we simply can't even imagine (like Donald Rumsfeld's "unknown unknowns"), the risk of exiting a state of relative complacency and hitting up against marked volatility is going to increase in 2016.
The Chicago Board Options Exchange Volatility Index (VIX) was relatively calm over the last couple of months, but episodes of extreme spiking, like the flash sell-off we saw in August, are probably coming back - perhaps even with a vengeance - as the market tries to place odds on the pace of future Fed rate hikes and other unknowns, if any.
So one hedging idea might be to buy the iPath S&P 500 VIX Short-Term Futures TM ETN (NYSE Arca: VXX), but I'd only recommend holding this over a relatively short period of weeks to one or two months as insurance.
And don't underestimate the value of cash as a longer-term hedge. But with the recent weakness in the U.S. Dollar Index telegraphing a possible end to its 18-month rise, consider a mix of normally stable currencies.
For example, I'd expect to see first and foremost the U.S. dollar, British pound sterling, and Swiss franc, but also the Canadian and Australian dollars, and now even the Chinese yuan all benefit from safe-haven attraction.
And thanks to exchange-traded funds (ETFs), you can easily gain exposure to any and all of these currencies with but a few keystrokes in your online brokerage account.
Here are the ETFs and their pertinent details:
- U.S. Dollar: PowerShares DB U.S. Dollar Index Bullish (NYSE Arca: UUP) ETF. As the world's reserve currency, the U.S. dollar should be part of your cash mix.
- British Pound: Guggenheim CurrencyShares British (NYSE Arca: FXB) ETF. As part of the EU but not the currency union, the pound is a natural haven for Europeans.
- Swiss Franc: CurrencyShares Swiss (NYSE Arca: FXF) ETF. Long seen as a neutral haven within Europe yet remaining outside the EU, and after having dropped its peg to the euro in January, the franc is pricier but still attractive for safety.
- Canadian Dollar: Guggenheim CurrencyShares Canadian (NYSE Arca: FXC) ETF. Being neighbor to the United States and after a considerable decline along with oil over several months, the loonie looks like a fantastic bargain right now.
- Australian Dollar: Guggenheim CurrencyShares Australian (NYSE Arca: FXA) With a relatively strong economy and also viewed as a commodity currency, the Aussie dollar is attractive, especially with FXA yielding 1.6%.
- Chinese Yuan: WisdomTree Dreyfus Chinese Yuan Fund (NYSE Arca: CYB) ETF. As the dominant power in Asia (and way beyond) and a soft peg to the greenback, China's currency is another haven of sorts. CYB has $112 million in assets and trades 22,000 shares daily.
Don't discount the importance of cash in your portfolio, and that means seeking diversification even within this most basic of allocations.
Remember, even if we can't actually predict black swans, that doesn't mean we can't protect against them.
Cash may not be exciting, but it sure feels good when everything's going to hell in a handbasket.