The Next Black Swan Is Right Around the Corner

Ever since the global financial crisis struck five years ago, investors have been looking ahead in fear and apprehension, anxiously awaiting the appearance of the next black swan.

Nassim Nicholas Taleb developed the black swan theory in his 2001 book Fooled by Randomness and his 2007 follow-up, The Black Swan. Like the occurrence of black swans in nature, these events are rare. What’s more, they tend to come as huge surprises and upend the usual order because they fall outside the realm of normal historical expectations.

The housing bust and subsequent credit crunch qualified as a black swan event because the scope of the damage to the global financial system was disproportionately large, compared with similar events throughout history.

The next black swan event might be manufactured right here at home.

But even though the stock market has bounced back and the economy is picking up steam, many people are wondering where the next black swan will come from. Some predict a huge storm will hit a major urban area, causing unprecedented damage. Others say a hard landing by the Chinese economy could throw the global financial system back into panic.

But what if the next black swan event is not thrust upon us from an external source, but manufactured right here at home?

Threat of an Artificial Bubble

Lately, President Obama seems to be focusing on the threat of artificial bubbles to the U.S. economy. Last month, he issued four warnings in five days, including during his weekly radio address Aug. 10. “We have to turn the page on the bubble-and-bust mentality that created this mess,” he said.

Some investors are reading the president’s concern as a repudiation of the low interest rate policies implemented by the Federal Reserve under Alan Greenspan, which spawned speculator surges in asset values — first, technology stocks in the late 1990s, then housing prices in the mid-2000s.

Throughout his term as Fed chairman, Greenspan’s successor, Ben Bernanke, has maintained an ultra-accommodative monetary policy designed to spur economic growth. But some are now asking if the elevated prices of stocks and other assets are, in fact, a new bubble that’s bound to burst.

If Obama is worried that this bubble-and-bust pattern will repeat under the Federal Reserve’s current leadership, the thinking goes, he may decide to pass over the central bank’s vice chairman, Janet Yellen, when Bernanke exits the Fed at the end of the year. Yellen is widely considered the favorite for the job, but if the president wants to encourage a change in monetary policy, he may look outside the walls of the Fed. And insiders say he will look no further than his former economic adviser, Lawrence Summers.

Enter Larry Summers

When most Wall Streeters heard that name floated as a candidate, their response was unequivocal: “No way.” They favored Yellen, who would maintain the central bank’s market-friendly stance. Their adamant opposition to Summers seemed to sway sentiment away from him. But many Fed watchers now say Obama still favors Summers over Yellen.

Jack Bouroudjian, CEO of wealth manager Bull and Bear Partners, told CNBC that there’s “a strong backlash from some industry watchers, with one going so far as labeling his potential appointment as a ‘black swan’ event.” That’s because Summers probably wouldn’t continue Bernanke’s easy-money policies.

Summers does have some history battling asset bubbles. In 1997, as President Bill Clinton’s Treasury secretary, he managed the U.S. response to the Asian financial crisis. And he was recognized as the strongest voice in Obama’s ear in the aftermath of the housing bubble’s collapse, when he served as director of the National Economic Council.

But Wall Street is less concerned about asset bubbles than it is about the possibility of upending the status quo. Investors know that the Federal Reserve must negotiate dangerous whitewater in the months ahead — namely, the need to taper its quantitative-easing program at a pace that won’t let the economy fall apart.

Wall Street Recoils

Wall Street is growing ever more fearful that Obama will ignore the vehement opposition and appoint his old friend and adviser to the Fed chairmanship. And that fear is already evident in the markets.

Click for larger version

The above chart shows the ratio of stock to bond performance. When the lines are rising, it indicates a “risk on” stance, as investors feel confident and favor growth-oriented investments such as equities. When the lines are sinking, it indicates a “risk off” environment, as investors switch to Treasuries and other investments perceived to be safer.

As you can see, the Summers speculation has coincided with a decided shift in market sentiment. In fact, the chart is starting to look a lot like it did last October, just before a stock-market swoon.

If Obama heeds the wisdom of Wall Street and appoints Yellen to head the Fed, we may see investors regain confidence and produce a “risk on” environment. But if he picks Summers, some investors might exit the stock market.

So whom will he choose, the heir-apparent or the black swan? Please go to Money and Markets’ Facebook page by clicking here and let me know.

Best wishes,

Douglas