Red foxes and black swans

2012-02-15 13:00

According to Nassim Taleb, a Black Swan is an event which is outside the realm of regular expectations. He calls it an outlier but foxes like Chantell Ilbury and myself prefer the term outsider, as in horse racing. Second, it carries extreme impact. Third, human nature concocts an explanation for its occurrence after the event.

Well, I have news for him since he has declared his support for open-minded foxes. You can capture Black Swan events beforehand using the technique of scenarios, flags and probabilities which we have evolved over the last ten years; and we have the track record to prove it. We would agree that you cannot predict these events nor can the future be reduced to any kind of mathematical or statistical model where human beings are involved. But, with decent imagination, you can write stories about the future in its most extreme form; with common sense you can identify the tendencies and flags which make a Black Swan event more likely; and, based on the tendencies or flags plus good intuition, you can apply subjective probabilities to the scenario which incorporates the Black Swan event.

The first example of showing how you do it comes from the mid-1980s before our model was fully developed. The Anglo American scenario team captured the idea of a negotiated settlement in South Africa in a scenario called the “High Road”. It was a Black Swan event for the country which at the time the scenario was formulated had exceedingly low odds. Indeed the “High Road” may have changed the odds by improving the conversation. The event of the 1994 election which in retrospect was called a political miracle had huge repercussions for South Africa. People are still trying to explain the reasons for its occurrence.

The second example was 9/11. In a letter to George Bush, published three months before 9/11 in a book entitled The Mind of a Fox, we rated a massive terrorist strike on a Western city as his key uncertainty. We did not accurately portray this Black Swan event in the way it took place as we spoke of nuclear terrorism, not planes flying into buildings. In other words, we had no idea of the method of delivery, but we had spotted two tendencies and one flag. The tendencies were the rising conflict between Islam and Christianity during the 1990s together with the re-equipping and reorganisation of movements dedicated to bringing down America. The flag rose with the two attacks on American embassies in Africa in 1998 which we felt were the prelude for the real thing on American soil.

The critical point of this second example is that if the American security agencies had entertained our scenario, they might have re-perceived some of the genuine flags to which they had access and we did not. It came out in the congressional enquiry after 9/11 that a young woman had been to her boss in the FBI on six occasions and told him there was a flying school down the road where Arabs were learning to take off but not land. They ignored the information because they probably suffer from information overload at all times. Nevertheless two of the suicide pilots went to the school and the authorities could have stopped the Black Swan event before it occurred.

The third example was the Great Financial Crash of 2008. We played this Black Swan event in a scenario called “Hard Times” back in 2005. Again we did not get the exact chain of events correct as we had never heard of sub-prime mortgages. However, we did have as a flag for this scenario a decline in property prices in the US. We figured that the principal asset of American consumers is their house; should it decline in value they would stop spending; since consumer expenditure is two-thirds of the American economy, this would trigger a recession first in America and then in the rest of the world; and such an outcome would have a calamitous effect on stock markets.

Subsequently, property indices in the US started falling in January 2007. They fell for six months in a row, so by July 2007 we were giving a 50% probability to “Hard Times” and advising clients to prepare a strategy for it. When stock markets began falling in October 2007, we raised the probability to 80% and when Lehman Brothers collapsed in September 2008 100% (for at least 12 months). These probabilities were based on our intuition and could have been wrong. We always tell our clients that they have the freedom to select their own flags and probabilities around a Black Swan event, but they must then have a strategy consistent with their beliefs.

So what are the Black Swan events that we now have in our portfolio which could happen in the future? There are two: one for the global economy and one for South Africa. The former we call “Forked Lightning” and the latter “Failed State”. In “Forked Lightning”, the Dow Jones Industrial Average falls from its current level of 12 900 to 1 500 and American investors lose close to 90% of their wealth. It is a repeat of 1932 when the Dow fell to 11% of its peak value in 1929. We consulted prominent individuals in the market and they were surprisingly consistent with the flags they chose: a sudden jump to over 5% in the annual interest rate on US 10-year government bonds which would indicate a loss of faith in the nation’s ability to get its financial house in order; and a default by Italy on its bond repayments which would cause turmoil in Europe because of the massive holdings of Italian bonds in the hands of banks, pension funds and other financial institutions. Incidentally, we are giving this scenario a current probability of 20% mainly as a result of the second flag beginning to rise.

In the “Failed State” scenario for South Africa, the Black Swan event is a huge jump in public violence along similar lines as that which occurred in the countries which have gone through the Arab Spring. The principal cause is high youth unemployment and the existence of social networks which give extra impetus to any budding revolution. The tendencies are there and it only needs one random trigger like what happened in Tunisia to convert frustration into overt action. Obviously the purpose of publishing this scenario is to lower the probability of its occurrence with remedial action, in particular getting young people off the streets and into jobs. At present we give it odds of 15%.

As Nassim Taleb correctly observes, no prizes are given to those who prevent a Black Swan event from happening. Indeed, the average reaction is to question what all the fuss was about. Be that as it may, you need the red foxes to sniff out the black swans and warn the world at large about them. A showdown between Iran and Israel is the next one to require investigation.

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