That Bird Looked a Lot Like a Black Swan – What Next? By, D. R. Barton, Jr.

Barton TT1Once-in-a-lifetime events seem to be coming every week lately…

Nassim Taleb defines a black swan event as an event that is unpredictable, has a massive impact, and after it happens, people try to rationalize it as if it could have been predicted. According to Taleb, the three traits of a black swan event are rarity, unpredictability and severe consequences.

It’s not hard to remember this type of disruptive event. Think back to 1987 and Black Monday. Or several moves in the market dives of 2000 and 2008, the flash Crash of May 2010 and the covid dive of early 2020 (and lots of others in between). We can now add a new one from the last few days to that list.

I won’t really discuss the Silicon Valley Bank and Signature Bank collapses much (I guess we can toss in a 25%+ cliff-dive Wednesday morning, March 15, from Credit Suisse into the mix), but I would like to re-open the discussion about what to do to protect oneself in these kinds of hyper-turbulent times.

But first, let’s look at what happened to Treasury bonds and some of the traditionally least-volatile assets around. I’ll start with a description of a black swan-like event from one of my favorite authors: Roger Lowenstein.

The concept of 10-sigma events was popularized by Lowenstein’s excellent book When Genius Failed: The Rise and Fall of Long-Term Capital Management. In his book, Lowenstein recounts that the Long-Term Capital’s models showed that the loss they (LTCM) suffered was a 10-sigma event, meaning that it should statistically happen only once ever – 1 times 10^24 days (a one followed by 24 zeros) – which means never.

But to nit-pick a bit, the first assumption required to call last a market move a 10-sigma event, is that the markets conform to a Gaussian or normal distribution. This is a model or assumption that is not representative of market price activity. Most analysts agree that the market is at best normally distributed with kurtosis (fat tails) and outliers.

This is basically a statistical way of saying that extreme events happen more often than can be predicted or really expected. And there are lots of outliers.

Let’s look at a graph from Creative Planning showing all the three-day moves in the 1-3 year Treasury bond ETF (SHY) dating back to July 2002. For more context, SHY is often used as a surrogate for cash in back testing engines.

1144 DR Chart1 1

Wow, a 12-sigma event! I didn’t even look at how many zeros that is. Short data bond prices exploded during the flight-to-quality cash moves over the last few days. And I hope you didn’t get caught up in a trade that was short bonds or long regional banks. But if you did, we’ll cover some thoughts in the coming weeks about what one can do in times of extreme volatility.

Specifically, as traders and investors, the relevant question of the moment is “What do we do about it?”

I’ve heard lots of discussion, especially around stop losses. And I’ve been asked these questions:

  • “Should I hedge positions?”
  • “Should we use close-only stop losses?”
  • “Should we quit using stop losses at all?”
  • “How can I protect myself against big drops like this?”

I’m going to revisit these topics in future articles. But for now…

Proper position sizing remains the MAIN source of risk management for traders and investors. Realizing a loss two or three times bigger than our planned risk amount (-2R or -3R in VTI terms) should not put our accounts in jeopardy if you have even an inkling about risk management.

Additionally, those who are investors or trading in longer time frames need to have some exposure to some positions with low correlation. If you mainly trade and invest in stocks, consider trading bonds, gold and other commodities as well. Even if you had multiple holdings that were completely uncorrelated, each and every one of them requires proper position sizing! Remember, there were almost no safe havens in the fall of 2008.

I always enjoy hearing your thoughts and comments. Send them to me using drbarton “at”

Great Trading and God bless you,

D.R. Barton, Jr.

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