We’ve watched with shock or surprise, depending on whose camp you’re on, as Donald Trump ascended to the White House. Nearly everyone was caught unaware of The Donald’s surge of support from the swing states of Florida, Ohio, Pennsylvania and Wisconsin.
The New York Times begun the night by projecting a strong 85% chance of Clinton winning but a few hours later they projected a 95% Trump victory. Endless polls were conducted and they all indicated a Clinton victory by a large margin. Although the FBI re-inquiry into Clinton’s emails did put a dent on her initial numbers, it didn’t affect her chances by much. The markets were essentially pricing in a Clinton victory – if not they wouldn’t react the way they did when Trump’s support surged through the battleground states.
The Dow was down 800 points at one point, S&P 500 and NASDAQ futures were limit down – which means they hit the maximum -5% for the day and the circuit breaker kicked in to stop further losses. The Mexican peso was down 10%, the Nikkei lost 1000 points and the Bank of Japan convened a meeting to discuss the extreme volatility in the markets.
I always believe that the markets are inherently made up of irrational human beings, and being irrational, mispricing does happen. How did the markets not see this coming? This election wasn’t the only black swan event that happened this year. In fact, 2016 was a year riddled with highly improbable events:
Leicester City’s stunning Premier League victory was so outlandish that bookies had them at 5,000 to 1 odds at the start of the season. It was highly improbable that a club made up of zero superstar football players could trounce other ultra-rich clubs filled with star players not just once, but over a majority of 38 games to win the coveted title. Leicester City has never won the Premiership title, and that put them at greater odds to win it.
Several hilarious comparisons were made with Leicester’s overwhelming odds, including the chances of former British Prime Minister David Cameron replacing Tim Sherwood as Aston Villa’s manager (at half the odds of 2,500 to 1) or Hugh Hefner to admit he’s a virgin (1,000 to 1).
We don’t really follow baseball here but their victory was also heard around the world. The last time the Cubs won the World Series was back in 1908. It took 108 years for them to win this title and it’s also a highly improbable if one simply used historical statistics.
Their win, however, isn’t as amazing as Leicester City as they had quite a stellar roster of players, compared to the stark imbalance suffered by smaller clubs in the English Premier League.
Now this hits close to home. Tt wasn’t highly improbable but it was still improbable because, statistically, no Singaporean had ever won an Olympic gold, let alone in swimming where Americans dominate the sport. It wasn’t as improbable as the above two examples but it was a sheer delight for Singaporeans rooting for him when he beat all-time Olympic great Michael Phelps at his own game.
This is still fresh in our minds and it bears the closest resemblance to Trump’s shock victory.
The “Leave” campaigners were led by boorish, brash, borderline racist and xenophobic leaders like Nigel Farage and Boris Johnson. The campaign played on the fears of the general populace, blaming migrants for almost everything that has gone wrong. Sound familiar?
The world thought it was outrageous and made jokes about the campaign and its leaders. Sound familiar?
Much of the British establishment thought it was outrageous and thought that it couldn’t possibly happen. Sound familiar?
David Cameron staked his career on it thinking that it was outrageous and even after Brexit happened, both Farage and Johnson had no concrete post-Brexit plans as they never thought they would win.
This was a classic black swan event, it saw GBP/JPY drop 16% in a single day, the pound weakened the most in thirty years. The consequences of Brexit have yet to come to a head as huge political shocks like this take time to unfold.
Nassim Nicholas Taleb is probably gloating (and he is) as his theory on black swan events shaking up core beliefs and sending markets into a tailspin come into full view of the global populace.
In finance, we’re taught that the bedrock of valuation is the discounted cash flow method, which relies moderately on forecasting of future earnings. If we can’t even get a company’s future earnings right (which we really can’t) or maybe within 5% of the actual earnings of the future, what makes us think that we are fully confident of the risks that we think we know?
Asset prices obviously didn’t factor in Brexit risk, or Trump risk, even though it’s plastered all over the news for months. How do we mitigate such risks? Black swan risks are perhaps the toughest amongst all risks because of its impossibility – we can’t see it coming.
In investing, we’re afraid of what we see – bad earnings, bad management, bad economic outlook, bad rumors in the forums and so on. But true risk is what we don’t see – hacking, terrorism, sudden political shifts, or death of a key management personnel. The markets usually price in the obvious risks that we see — like an earnings miss, the stock price will instantly reflect the change in the company’s value, but the market will never price in an unexpected Trump victory or the 9/11 attacks.
Sure, those unseen and improbable risks are actually mentioned in the risk section of every prospectus and annual report – but who reads them? They’re all almost the same across different industries and sectors. It’s the individual company risks that stick out like sore thumbs, glaring at a keen-eyed short seller and enticing him to dig further information and build a short thesis and position.
Political risk is in almost every company’s risk section but no one pays attention to it, why should they? It rarely ever happens. But when it does, it can sometimes end a company – e.g. the end of a mining license due to a change in governors of that municipality in which the mine is located at. The stock then tanks massively before one can react.
These highly improbable events are impossible to predict and it’s best as investors that we avoid trying to predict them. It will always end up against our favor or worse, our positions. Humans aren’t oracles, we can’t predict the future. Yet endless humans place bets – be it money, career or even our lives on future events that they have absolutely no idea of the real outcome.
The fifth perspective
As investors, we shouldn’t try too hard in predicting the future – it just won’t work out the way we think it will go.
Unforeseeable market-wrecking risks are also beyond our reach but we have the power and knowledge to steel ourselves against such events.
Invest in companies that you know won’t be too affected by outside events. Look at Singtel, for example:
- Will a Trump victory affect Singtel’s earnings?
- If so, would the massive drop in its stock price on the day of Trump’s victory be considered fair?
Knowing that such events can’t be foreseen, we can then watch the market have a kneejerk reaction to the news and watch all the stocks being taken to the cleaners. We can then ask the question (using Visa as an example):
- As an American company that sells its card services globally, would it be affected by political instability? Yes, by how much?
- Will the countries they do business in suddenly revoke their licenses, but risk angering millions of consumers with Visa cards?
- Will the banks issuing Visa cards suddenly stop distributing Visa just because of a Trump victory or a Brexit?
Mispricing often occurs during wild swings in the market and that’s where you load the bullets into your gun and steady your aim for the kill. If you have an existing portfolio of assets that are taking a hit, you can ask yourself the same questions:
- Will this event affect Companies A, B & C in my portfolio? If not, as their prices drop, is it an opportunity for me to buy more due to the mispricing?
- Will this event permanently degrade Bond A in my portfolio? If so, should I let go of it now or wait till the market recovers from this shock move?
As we’ve mentioned many times – investing is psychological warfare. You’re not in competition with Wall Street’s brightest; you’re in competition with yourself.
Watch how you reacted when Brexit happened or when Trump won the US elections. How did you react? Were your emotions and actions in line with the markets? Or did you smell opportunity and ran to fire up your brokerage account to sniff for opportunities? Only you know the answer, and you know how best to react in such situations in the future because this will happen again.
(Photo credit: Gage Skidmore)