The Most Unpredictable Market Event

The Black Swan Theory describes unpredictable events of extraordinary magnitude. The meltdown of 2008/2009 would be a perfect example of a major Black Swan event.

This theory, developed by Nassim Nicolas Taleb, describes a Black Swan event as one of three things:

1. The disproportionate role of high-impact, hard to predict, and rare events that are beyond the realm of normal expectations in history, science, finance and technology
2. The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities)
3. The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs

In essence, a Black Swan event is something that has such a small chance of happening that it’s not accounted for in the models that the quants (quantitative analysts) use to predict risk.

These quants use statistics to figure out just how probable a trade is going to be. Being a bit of a math junky myself, I use these same calculations. But being a trader, which many quants are not, I know there is a human element that NO model can predict.

What most of us don’t realize is that Black Swans happen much more often than we think.

In fact, we could be on the precipice of another…

Usually the worst Black Swan events in the market occur when people are off guard or beginning to feel like a major problem has been solved.

When markets are emerging from what appears to be a bottom and major catastrophe seems to be averted, our defenses are down. Black Swan events occur just when everyone is feeling comfortable, not vulnerable.

This was exactly what happened at the end of 2008, right around the time the world’s investment guru Warren Buffett injected $5 billion into Goldman Sachs (GS:NYSE). Shares were trading at around $125.

During the week of Sept. 19, Goldman Sachs (and the S&P 500) moved six standard deviations to the downside… It traded all the way down to $85. This is a big deal… Standard deviation is a measurement used to determine normal movements in the stock market. Super savvy investors use these types of measurements.

In plain English, the chances of a six standard deviation move occurring in a day’s time are one in 506,797,346. Which means it should occur once every 1.388 million years.

Goldman Sachs’ move happened over a week’s time, so perhaps the chances of this happening are a little greater, but you get the picture. This seemed like a once-in-a-lifetime event. Many investors thought it was, and started to buy along with Mr. Buffett.

A couple months later, the market and Goldman Sachs fell another 50%… What were the odds of that?

Two Black Swans in four months!

And more trouble could be brewing.

Paper Optimism

Poring over the economic data of the past weeks, I can’t find a single reason to buy stocks right now. I sure as heck can’t rationalize the rallies we saw these past couple days in the face of negative news.

Perhaps the poor data will be the impetus for QE3 or whatever our Fed friends decide to call it. For some reason, the equity markets think that will save us.

I disagree.

The seemingly positive news yesterday that pushed markets 1.5% higher isn’t really good news. The European Central Bank and several reserve banks will “create” dollar liquidity for Europe’s dried-up financial system. It doesn’t make sense to me. Where are these dollars coming from? They will either have to be paid for or printed, neither of which is an attractive option.

When the market starts to react in a completely abnormal and almost irresponsible way, my ears perk up and my stomach starts to churn. To me, the happy-go-lucky attitude the market has scares me. It has no reason to be.

From my perspective, I see the recent sell-off as the first leg down with more to come.

Formations Point to Movement

To confirm my thesis, I’ve started tracking Flag and Pennant formations developing in the major indexes: the S&P 500 (SPX) and Dow Jones (DJX).

Flags and Pennants are short-term continuation patterns that mark a small consolidation before the previous move resumes. These patterns are usually preceded by a sharp advance or decline with heavy volume, and mark a mid-point of the move.

These pennant formations could spell trouble or at least volatility in the near future.

Here’s what I am seeing:

Dow Jones

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S&P 500

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Charts and sentiment can be powerful motivators. If millions of technical analysts are sitting at their desks with sell orders armed and ready and the market witnesses a real crisis, selling will come sharp and swift. Be prepared! Use these rallies to take profits.

P.S. You can also use options strategies like the covered call to protect yourself. This week, I talk about covered calls and the coming week’s data in our new FREE podcast series; check it out here.

No one ever went broke taking profits. This is a market where being proactive is a necessity, not an option.

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Other Related Topics: Investment Strategies , Jared Levy , Market Analysis , Option Strategies Weekly , Safe Investments , Stock Market Analysis

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