Stock Smarts: Goldilocks and the Black Swan

With stock indexes at record highs, there is talk of a Goldilocks market that could run for some time. But watch out for the black swan!

Ho-hum. Another new record for the Dow. And the TSX. And the S&P 500. The markets just won’t quit. It’s great for everyone who owns stocks. But as each old record falls, I grow increasingly nervous.

Stock markets don’t go up forever. Sooner or later, they crack. The question that keeps eating away in the back of my mind is when will it happen this time?

Well, maybe not for a while yet. Everyone keeps talking about how this bull market has been running since March of 2009, which marked the low point of the financial crash that began with the collapse of Lehman Brothers the previous September. But in fact, the bull went on holiday in 2011. The S&P/TSX Composite Index lost 11% that year while in New York the S&P 500 was flat. Most major overseas markets were clobbered that year with Hong Kong’s Hang Seng Index falling 20%, Tokyo’s Nikkei losing 17.3%, and the Frankfurt DAX dropping 14.7%. So it hasn’t been a straight uphill dash since 2009.

Some analysts are now suggesting we’re enjoying a “Goldilocks market” – not too hot, not too cold, but just right. This in turn is tied into a so-called “Goldilocks economy” in which growth takes place at a measured pace – strong enough to maintain a sense of forward momentum but not so strong as to prompt fears of bubbles, inflation, and interest rate hikes.

Last week CNBC quoted Craig Johnson, senior technical strategist with Piper Jaffray, as predicting the markets will continue to thrust higher. “We think the stock market is ready to make new highs once again,” he said. “We continue to see money flow coming out of fixed income and coming back into equity funds, and with our charts we continue to see the economic sensitive sectors of the market such as consumer cyclical, industrials, and financials continuing to show many constructive, longer-term charts.”

Of course, one analyst does not a market make and there are plenty of naysayers out there as well. But one thing that is missing from all the analyses is the proverbial black swan – the unexpected event that changes investor attitudes fundamentally and drives stock prices lower – or, occasionally, higher.

The concept was conceived by Nassim Nicholas Taleb, who wrote two books on the theme: Fooled by Randomness in 2001 and The Black Swan in 2007. Examples include the crash of 1929, the Lehman Brothers failure, 9/11, the 2011 earthquake and tsunami in Japan, and, in a positive sense, the sudden and dramatic emergence of the Internet.

The turmoil in Iraq and Ukraine both have the potential of developing into black swans if they were to escalate into major regional wars, or worse. But so far, they have been contained. The momentum of the Sunni insurgents in Iraq appears to have been blunted by counter-attacks from government forces and military aid to Baghdad from the U.S., Russia, and Iran. In Ukraine, all parties have a vested interest in preventing the incipient civil war in the eastern part of the country from expanding beyond the border. Even Russia, which is accused of fomenting the trouble, appears reluctant to push too hard.

So what else might happen to send Goldilocks packing? Natural disasters are always a possibility although it would have to be something on a massive scale to have a significant impact on market sentiment. The collapse of a major financial institution would certainly trigger a sharp correction or worse and that’s always a possibility despite tougher capital requirements. An even greater danger is a domino-like meltdown in China’s shadow banking system, which appears to be seriously overextended. Even the Bank of Canada has expressed concern about that one. Or the black swan could be something we can’t even conceive of at this time. Events like 9/11 came right out of nowhere – no one saw it coming.

If there is no black swan on the horizon, then the bull market could continue to run into 2015. But keep in mind that if this upward trend holds until September, it will be the longest bull market since the Second World War. That’s asking a lot.

Even if this bull run continues, I still expect the market to pull back and consolidate at some point this year. Corrections within a secular bull market are normal and healthy but if we get one we need to be sure it’s not the start of a new bear before we go bargain hunting.

I’ve advised taking profits where appropriate before and I reiterate that advice now. Goldilocks didn’t hang around the house forever. At one point the bears came home and she fled into the woods.


Gordon Pape’s new book, RRSPs: The Ultimate Wealth Builder, is now available for purchase at 28% off the suggested retail price. For information on a three-month trial subscription to Gordon Pape’s Income Investor newsletter go here.