Black Swan Event: Will the S&P 500 Drop 40%?

Yesterday on CNBC, Mark Spitznagel, chief investment officer for fund manager Universa Investments L.P., made a scary prediction. He warned that the S&P 500 could lose 40% of its value in the next couple of years.

He went on to point out several facts and figures that led to this prediction. He specifically said, “there is a 20% chance of a well-over 40% correction in the S&P 500 within the next few years.”

CNBC even had viewers voting on this black swan event.

So will the S&P 500 drop down to 760?

The Black Swan Theory

The Black Swan theory was developed (popularized) by Nassim Nicholas Taleb in his 2007 book of the same name, The Black Swan. The term is now used throughout the investment community to describe unexpected events (outliers) of large magnitude and consequence.

Coincidentally, Taleb is a “scientific adviser” at Universa Investments, the firm that is making this prediction. Universa’s specialty is providing protection against these cataclysmic events for clients.

Basically, you can think of a black swan event in this case as an event that doesn’t make statistical sense at the moment, but has a small probability of occurrence. Not only can these “outliers” or extreme unpredictable events be catastrophic for our wallets, but they may change the way we look at the safety of our investments forever.

If more of these black swan events occur and are burned into our memory, we may begin to believe that these abnormal events are more common than they are and those subsequent fears may actually exacerbate the repetition of these occurrences. It’s like having five tornadoes hit the city of Philadelphia in a summer — something that seemed impossible is occurring in front of your eyes and becomes reality, and it triggers massive changes in the minds of the people that live there.

That’s a good thing for a firm like Universa Investments, so it’s convenient for them to stir up a bit of fear in investors’ minds. But perhaps it’s a good thing that we are aware of these possibilities and protect ourselves.

But will it really happen?

What Are the Chances of a Black Swan Event?

As an option trader, I am looking at the potential for these sorts of occurrences all the time. Believe it or not, mini catastrophes and outliers happen every week. We option traders usually know what to look for when it comes to signs of impending doom.

But sometimes there are no abnormalities or warnings of these types of events, and that’s when funds like Universa make big profits.

Take Research in Motion (RIMM:NASDAQ), for example. It went from $70 per share down to $29 per share in less than 120 days. The options did NOT predict this early on. Statistically, there was less than a 0.05% chance of this happening.

The prices of the options that I trade actually can help us find where there is fear of uncertainty. They also indicate how volatile investors think a stock will be. This is similar to how the high yields of Greek sovereign debt tell us that there is a high risk of default.

I did some basic calculations using my own techniques and found some interesting statistics:

• Looking at the options prices in the SPX and how the index has moved over the past year, I actually came up with the same probability as Mark Spitznagel.
• I see a 19.89% chance that the S&P 500 (SPX) could get down to 762 by June 18, 2014 — which would be a 40% drop.
• I also figured that there is about a 10.5% chance that it could go back to the low of 666 by June 16, 2014.

(This isn’t the first time Smart Investing Daily has discussed Black Swan events. Sign up for Smart Investing Daily and stay up-up-date with my and fellow editor Sara Nunnally’s easy-to-understand articles.)

So What Could Really Happen to the S&P 500?

For the market to drop so dramatically, there has to be a catalyst, something out of the ordinary — a black swan needs to create a black swan event, if you will. Back in 2008-09 it was a complete meltdown of the banking system and housing market that sent securities 57% lower…

Looking at the charts and some basic fundamental estimates, it’s more realistic that a correction would bring us down to the 1,100 level in the next year.

But I wouldn’t look toward the charts in the S&P. I would instead focus on the potential catalysts for catastrophe: a bubble bursting in China’s housing and growth boom, a major terrorist attack, earthquake or other natural disaster, a double-dip recession here in the U.S., eurozone stability crumbling under sovereign debt contagion, etc.

Any of these situations could occur; the questions you have to ask yourself are:

• What’s the probability of an occurrence?
• How will my portfolio be affected?
• What am I doing to hedge (protect) myself?

How Do You Profit or Protect Yourself From This Potential S&P 500 Drop?

You can protect yourself without paying a company like Universa to make sure you are hedged. Learn to use options, and option spreads specifically! They can dramatically reduce your risk and exposure to events like this. They can also increase your probability of success in your trades!

You can also buy put options against your long stock positions. These are called “married puts”; basically they are like insurance policies for your stocks. In my book, I discuss all of this in detail. If you want to learn more, you can pick up a copy here.

I actually used an option strategy on RIMM because I believed that the company would get smart and turn around. They failed miserably, but instead of losing $40 on the trade, I lost about $8. This was much more tolerable, and I can now deal with my mistake and move on as opposed to having my account decimated.

We will all have losing trades and make mistakes, and every so often when that black swan appears, you will want to be prepared. Instead of losing it all to the swan, use the right strategy to dramatically reduce your risk and live to play with the black swan another day.

P.S. I mentioned earlier in the week that we have a huge conference coming up in Vegas on surviving the markets. Details for that will be coming shortly, so stay tuned. We are also offering a free money crisis webinar on June 20 that I urge you to check out. You can sign up here.

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How to Protect Your Portfolio From Black Swans

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Black Swan Events in Korea?

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