The Black Swan That Drove Us Into a Cave

I have to tell you, I’ve been tossing around ways to describe the last month in financial markets all evening. And here’s what I’m going to settle on: if September wasn’t enough, someone had to add October.

And I’ll leave it at that. We’ve all heard about it, read about it, talked about it, so I won’t go through the litany of events. Looking back, two things stand out for me (well, three, if you count Obama, but that would really be November). First was the relentless bloodletting. If September was the mother of unexpected events, October was the mother of extreme reactions. On October 6, I saw my optometrist, and of course, I couldn’t resist talking about stocks. It just so happened that her stock broker had called that morning, and this was his message: “sell everything”. Shocked, I asked, “Why would he say that?” And the answer was, “Because you just don’t know how much worse it could get.”

For the record, I think that was absolutely terrible, horrendous advice. But it wasn’t uncommon. I remember October for the wild swings, the days of down 500-700 points in the last hour. That was the sound of people selling, of brokers telling their clients to sell, of redemptions driving the market down like crazy. A friend asked me, “what happens to all that money that comes out of the market? Where does it go?” My answer wasn’t very comforting: “Those are real losses. That’s real money disappearing.”

The other thing I remember October for is that governments, and people in general, finally realized that they had to do whatever it takes to fix the system. President-Elect Obama (I love saying that, by the way) called this time “the worst financial crisis in a century” (we know he really meant the worst financial crisis since the Depression). Even yesterday, John Thain, CEO of Merrill, said that the environment recalls 1929, the beginning of the Great Depression. “It is not like ’87, it is not like ’98, it is not like 2001,” Thain said. Meaning it’s worse than any crisis in recent history. At the price of great blood, we finally have people and governments willing to act, to do whatever it takes, to stabilize and normalize markets. I call that good news, because that means the doctors are in the house. I would say that before, the doctors were outside, drinking their scotch and saying, “the patient will be fine, he just needs to work through it.”

Now for the question on all of our minds – “ “What now?” Unfortunately, we’ve come to realize that even if governments do everything they can (aka whatever it takes), it’s not enough. Let’s just say the doctor went in and did his thing, the patient is out of the ICU, but he’s not out of the hospital. The patient is critical, he’ll make it, but he still has to fight and he could easily get worse before he gets better.

If you look at the market, it’s moving a lot, but it’s pretty much on the bridge to nowhere. It’s been range-bound, it’s not really going up or down. Just sideways. I think we’ll be here for a while.

The Black Swan

For a very long time, Europeans saw only white swans, and so they thought all swans were white. Then they found black swans in Australia, and they realized that they were wrong. Philosophers and thinkers then used this story to illustrate a bigger problem in life: even if you see a million white swans, it doesn’t mean that all swans are white.

Today, the black swan has come to symbolize the unexpected and the improbable. In short, we see white swans everywhere, and so our minds create rules and generalizations that makes us feel like we understand the world around us – “ i.e., that all swans are white. Because of this tendency, we tend to be ill-equipped when we run into life’s black swans.

Nassim Nicholas Taleb, in his 2007 book, The Black Swan, added a new twist to the concept of the black swan: that it is the improbable, the unexpected events that have the highest impact. In fact, he argues that in history and in science, this is the rule rather than the exception.

Welcome to the black swan of our time (well, at least the financial black swan). It’s pretty easy to see that almost no one expected the depth and breadth of problems we face today. And that little thing about the improbable having the highest impact? I think that fits current events.

The Cavemen (or Cave People) We Are

So great, interesting concept, but how does it help us? Obviously, the next time around (and there will be a next time), we have to spend more time thinking about the black swan that may come into our lives. But for today, if you accept the argument that we are in extraordinary times, then you also have to accept the corollary: that fixing all this is going to take a long, long time.

The markets reflect this sentiment. The few bold buyers venture in and try to lead a charge. Then the sellers come in and clobber them. Even as I write, we are driving toward another retest of recent lows.

Investors are hiding in the caves, waiting for the air to clear, trying to make sure that there’s not another bigger black swan around the corner. And so for the short- to medium-term, don’t expect much. The market will dilly-dally and dawdle.

The market is right, of course. There are still several problems coming down the road, including credit card debt, auto loans, student loans, deeper commercial real estate problems, and more companies going into bankruptcy (alarming when we get specific, isn’t it?) So is it any surprise that buyers are hibernating?

Memory

There’s another factor to consider when looking at the market these days, and that’s memory. And I’m talking memory from a technician’s point of view. I’m not much of a technician, but sometimes, the technical concepts are very useful. Let’s start by taking a look at the chart below:

Technicians like to look at resistance. Stocks tend to move toward an upper resistance level, but have a hard time breaking through that resistance. More often than not, the stock reverses when it hits resistance as sellers start to outnumber buyers. The same is true, in reverse, on the downside. Sellers will drive stocks down toward a resistance level, and then buyers will step in at resistance and drive the stock back up.

As you can see from the chart above, I’ve marked the upper resistance level as a range from about 9,000 to 9,400 on the top end, and the lower range as somewhere around 8,200. For the last month or so, the market has been locked in this range.

Why does this happen? Let’s suppose that you bought stocks when the Dow was about 9,400 somewhere in the last month. For the most part, you’ve been in the red as sellers drove the Dow down to the 8,200 range. As stocks go back up to the 9,400 level, you’re thinking, “Sell!” You remember that 9,400 range because that’s where you bought, and as soon as you get back there, you’ve joined the ranks of the sellers. So each time we approach 9,400, sellers pile in, making it hard to break through this resistance level.

The same is true on the downside. You remember the 8,200 range and you say, “Wow, stocks can’t get much lower.” And then you buy.

Know that these resistance levels can change and evolve. But generally, you can see why the market is range bound. We need an event, or some fundamental indicator to tell us we should break out the range. For example, if earnings were better than expected, we could break through resistance. Given that most companies are reducing forecasts, it’s unlikely we’ll break through the upper resistance level any time soon.

Likewise, events could drive us below the lower resistance levels as well. For example, if Congress decides not to help the auto industry, that could make things much worse, and we could drop past 8,200 on the Dow very quickly.

Know also that the concept of resistance is neither perfect nor exact. That’s why I sometimes use a range. Also, resistance is not always the closing level. The intraday low over the last month was actually around 7,800, so that could be the actual resistance level.

Redefining Capitulation

If you listen to financial news or watch CNBC, you will often hear of “capitulation”. Usually it’s described as a day, or a few days, where the VIX (the volatility index) goes crazy, volume is really high and the indices hit a major low. The theory seems to be that at such a time, investors have “given up”; they’ve thrown in the towel and sold everything because they’ve lost confidence. That clears the air and gives buyers waiting on the sidelines a chance to step in and drive the market up.

I was never a fan of this idea. I always thought it was strange to point to a single event, or a few days, and say, “That as the turning point!” Experience, and history, should tell us that there might be an immediate catalyst, but history is made by the build-up of many small events over time. Basing your investment on a seminal event, like a Boston Tea Party, seems to be a bit weak to me.

I think capitulation happens over time. If anything, I think capitulation is a slow, drawn out process. And I think we’re in the middle of it now. Today, we have a key attribute of capitulation: buyers have given up. They’re sitting on the sidelines, just waiting, looking for proof that there’s not another market dive coming.

Being range-bound, while frustrating for the bulls, is not necessarily a bad thing. It means that the bulls and the bears are battling back and forth. If we continue to test the lows but don’t fall through, that’s actually good news. Think about it – “ so far, we’ve fallen through every low we set this last year.

The Best Time to Buy?

I’m sure you’ve asked, is this a good time to buy? Yes, it is, if you have a long term view. Of course, the problem is that many of us were already invested in the market. That means many of us are in the red, and don’t really have much cash to invest.

The other thing to keep in mind is that “the best time to buy” is a range of time, it’s not today or tomorrow. It’s probably the next several months, maybe even six months to a year. And as I always say, it’s pretty hard to pick the bottom. If you watch Buffett carefully, he often buys and is in the red for a significant period of time before a stock turns positive. Then it’s an even longer period before the bulk of his profits are made. Such is the advantage of a long-term investing horizon.

It is a great time to buy, but we do have time. We are in the middle of working things out, letting the patient fight his fever or his infection before letting him out of the hospital. That will just take time.

Last month, I ended by saying this month might be a little less interesting than last month. Well, it is. And next month might be a little less to. And so on, albeit it slowly.

Until the next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.