Black Swan or Black Turkey?

The Great Recession is just the latest financial ‘black turkey,’ said the CFA Institute's Laurence B. Siegel at the Morningstar/Ibbotson conference in Orlando.

“Black swan,” the phrase that Nassim Taleb’ s bestseller of the same name affixed to the financial lexicon, is typically used to describe improbable catastrophes that defy any reasonable prediction.

Some people have suggested that the financial crisis of 2007-2009 was a black swan event. Others, like Laurence B. Siegel, the research director of the Research Foundation of the CFA Institute, think it was a bird of a different feather.

“We didn’t have a black swan. We had a black turkey,” said Siegel, who offered a post-mortem of the crisis—and suggestions for investment strategies going forward—at the Morningstar/Ibbotson conference in Orlando March 5.

Larry SiegelSiegel, who edited his organization’s new book,  “Insights into the Global Financial Crisis,” defined a black turkey as “an event that is entirely consistent with past data but that no one thought would happen.”

An explosive mixture of leverage and volatility was the proximate cause of the crisis, Siegel said, in a presentation that tried to summarize in 45 minutes the views of the book’s 20-some contributors. As interest rate spreads shrank, investors resorted to leverage and speculation to make money. Then spreads widened.

But the deeper cause was government meddling in the markets, he believes. Government responses to earlier crises have added layer after layer of moral hazard to the system by mitigating the cost of failure. Like the controversial policy of suppressing natural forest fires, it only fueled the fire next time.

So people took absurd risks, trusting that the Invisible Hand wouldn’t slap them silly. But the pendulum inevitably swung the other way. “It was totally predictable,” said Siegel, who has an MBA from the University of Chicago and favors Chicago School, free-market solutions. “Big declines always follow huge advances.”

Far from being rare, he said, black turkeys occur regularly in high finance. He listed “a flock of turkeys” since 1911, including six stock crises in the U.S., a 40-year bear market in long Treasury bonds after 1941, gold and oil bubbles in the 1980s and a 20-year bear equity market in Japan. (See chart).

In the latest crisis, the government’s culpability extended beyond moral hazard, he said. Invoking the views of Peter Wallison, an American Enterprise Institute fellow and a contributor to the book, Siegel traced the crisis to efforts during the Carter and Clinton administrations to encourage lending to low- and middle-income homebuyers.

But the recipe for a truly disastrous housing bubble was not complete until the George W. Bush administration, when the Department of Housing and Urban Development required Fannie Mae and Freddie Mac to step up purchases of loans made to low income borrowers.

A Flock of Turkeys
Asset Class Time period Decline
U.S. stocks* 1911-1920 51%
U.S. stocks (DJIA, daily) 1929-1932 89%
Long U.S. T-bonds* 1941-1981 67%
U.S. stocks 1973-1974 49%
UK stocks* 1972-1974 74%
Gold 1980-1985 62%
Oil 1980-1986 71%
Japanese stocks 1990-2009 82%
U.S. stocks (S&P) 2000-2002 49%
U.S. stocks (NASDAQ) 2000-2002 78%
U.S. stocks (S&P) 2007-2009 57%
*Real total return. Source: Laurence B. Siegel.

As the crisis unfolded in the fall of 2008, the government should have restored liquidity to the financial system but, in his view, shouldn’t have bailed out companies like AIG. The financial system, which by that time accounted for 40% of the profits of the S&P 500 companies, needed to slim down.

Unemployment in the financial sector has provided “creative destruction,” he said, and as a result we’ve “seen a return toward equilibrium in financial services.”

Going forward, Siegel advised money managers to look for inflation hedges. That means Treasury Inflation-Protected Securities and floating rate note funds for those who want maximum protection, plus cash in case high interest rates follow inflation.

For investors less willing to sacrifice return for safety, he recommended real estate, commodities, non-dollar denominated assets, real asset-related private equity, and equity investments in companies with fixed nominal costs and variable revenues.

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