IMO Black Swan Image

I was confused. Though a familiar sound, my deep sleep didn’t allow me to register what it was. Through the fog, I realized my cellphone was ringing. I looked at the clock—6:47 a.m. I immediately assumed the alarm company was calling because an employee had accidentally triggered the alarm at the office. It happens. Then I looked at the name of the caller, and it was my executive vice president. Oh boy.

Last Tuesday, 12 communities in Oakland County, Michigan, including Bloomfield Hills where my office is located, woke to the news that a 48-inch water main had burst the night before. The pipe, installed in 1970 and meant to last 100 years, had failed. More than 260,000 residents had low water pressure, over 51,000 no water at all. But that wasn’t all, and it was the reason my phone was ringing at 6:47 a.m. Early that morning, the Great Lakes Water Authority had issued a boil-water advisory for the affected towns, and our office was smack in the middle of it.

We were lucky. At least we had water for the restrooms. Many restaurants and office buildings had no water, having to close and send employees home. Even some hospitals were dry, relying instead on reserve tanks to keep patients and staff comfortable while canceling elective surgeries. All we had to do was bring in cases of bottled water to run the coffee makers and replace the water coolers, which are piped to the building’s water supply. The staff rallied, and after the initial drama of routines disrupted, work went on, including our end-of-the-summer barbecue on Friday.

After the advisory was lifted, we had the task of purging the water lines in our kitchens and water coolers, replacing refrigerator filters, and dumping ice to ensure no bacteria remains. And, wouldn’t you know it, even that process had a glitch first thing in the morning, as the sump pump in one of the kitchens failed, resulting in an overflowing sink as we ran the faucets for five minutes to purge the lines. An inch of water on the floor and soaked carpeting created another unexpected crisis.

We never saw it coming—first the water main break and then the flood. We have a business continuity/disaster recovery plan in place as mandated by the SEC, so the staff is trained to handle power outages and the like. But no drinking water? In the richest county in Michigan? This came out of nowhere. Like a black swan.

The unexpected. By definition, you can’t plan on it—it’s not anticipated, it’s never happened before. Just as we couldn’t have known that we would need to have a four-day supply of bottled water on-site to handle a once-in-50-year occurrence, black swan events in the markets can wreak havoc on your investments.

Fortunately, you can be more prepared than we were when we were faced with bacteria-laden water. When you invest in a diversified portfolio of noncorrelated, risk-managed strategies, you anticipate that “stuff happens” and you can mitigate the losses that occur in a black swan event, leaving you more capital to participate when the markets recover.

Market update: A bull in the china shop market

The markets continued to soar last week. All of the major indexes were up (the small-cap Russell 2000 was the exception). Unfortunately, bonds and gold did not follow suit, as they both registered small losses.

The S&P 500 Index has now been up seven weeks in a row. Furthermore, since the election, the market has had positive total returns in each of the 12 months that followed. Historically, when the market rallies 10 or more months in a row, the results have been very positive for the subsequent period. Although the month is down when the streak is broken, the next three-, six-, and 12-month returns are generally positive, as can be seen in the S&P 500 chart that tracks out each of the 10 or more occurrences.

S&P 500: 1930-2017

Similarly, one can look at the 10 years that most match this year (on a daily-correlation basis). The market in each case was up between now and the end of the year. The average gain was 6.2%, which even bested the average very good year-end finish that we have come to expect (5.4%). Interestingly, in nine out of 10 cases, the market was higher at this point than it is this year, suggesting this market could do even better in its final months.

The market was recently characterized as a “bull in the china shop” by Bespoke Investment Group. This was due to the market’s propensity for rallying in the midst of so many perceived threats: North Korea, a tightening Fed policy, overbought and overvalued conditions, and daily “news breaks” from the politicians in Washington.

Yet, everything in the world of finance seems to be running counter to these threats. We had 22 economic reports last week. Sixteen of them beat expectations, while another four were on target. Only four failed to meet the experts’ outlooks. A special surprise was the GDP announcement, which reported better-than-expected 3% growth.

The 3% GDP growth unexpectedly comes in the face of three hurricanes, and all of the damage they have wrought. Yet, a look at the number of unemployment compensation claims (also reported last week) confirms that the storms were but a blip on the nation’s radar screen.

Initial Jobless Claims

Most importantly, earnings continue to sustain the market rally. With about 1,000 firms already reporting, over 63% have topped analyst predictions on earnings per share, and 61% have bested their projections on revenues.

This continued growth in earnings is essential to the continuation of the rally in equity prices. The performance of the stock market is 90% correlated to the growth in corporate earnings.

S&P 500: Price VS Earnings

Despite all of this good news, the contrarian in me is screaming to beware of the unexpected. Corrections can seemingly come out of nowhere.

Dynamic risk-management strategies, when held in an uncorrelated portfolio of such strategies or in conjunction with a conventional buy-and-hold or strategically allocated portfolio, can help mitigate losses occasioned by these black swan events.

Life is back to normal both in our office and in the market. But winter is coming to Michigan. We expect freezing temperatures resulting in ice and snow. This we’re prepared for. Are your investments similarly prepared for the inevitable, as well as the unexpected?

P.S. Thanks to my executive vice president, Renee Toth, for writing the first half of today’s article.

Disclosure: No communication by Dynamic Performance Publishing or our employees to you should be deemed as personalized investment advice. Any investment recommended in this newsletter should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company. Dynamic Performance Publishing, its affiliates, and clients may hold positions in the recommended securities. Results are not indicative of holdings for clients of Flexible Plan Investments. Forwarding, copying, or otherwise duplicating this information for the use by anyone other than the intended recipient is expressly forbidden. These results are not representative of those achieved by clients of Flexible Plan Investments, Ltd. (FPI) due to differences in security selection, timing of trades, transaction fees, and FPI’s management fees.