3rd Quarter 2016: Brown Cows & Black Swans

BROWN COWS & BLACK SWANS

My niece, Martha Kate (15) was crestfallen when the veterinarian announced that Suzie, Martha Kate’s cow, had lost her calf and was no longer pregnant. My brother John and his wife Catherine had finally given in to Martha Kate’s begging and pleading and given her a milk cow for Christmas last year. The local farmer who sold John the cow offered a special “buy-one, get-one-free” deal. Yes, Suzie was pregnant when she arrived on the farm. Martha Kate was beside herself with excitement as she began preparing for the arrival of the baby calf. But then, a month prior to Suzie’s approximate due date the veterinarian delivered the bad news of the loss of the calf after a thorough examination of Suzie’s insides. It was a sad day on the farm. More on this later.

In 82 AD, Roman satirist Juvenal originated the notable Latin expression, “rara avis in terris nigroque simillima cygno,” or “a bird as rare upon the earth as a black swan.” In the first century, a black swan was impossible to fathom. Swans were white! At least that was the case until the seventeenth century when Dutch explorers first documented sightings of black swans in Australia. Since then, the term “black swan” has been used as a metaphor to describe the occurrence of highly improbable events. Examples from history might include inventions such as the wheel, the printing press, the steam engine, the telegraph and the internet. Events might include the births of Jesus and Muhammad, the Protestant Reformation, the American Revolution, World War I, the rise of Hitler, the fall of the Berlin Wall and the 9/11 terrorist attacks. Each of these inventions or events were improbable and yet each had a major impact on civilization.

Author, professor and former Wall Street trader Nassim Nicolas Taleb further developed black swan theory in his 2007 bestseller, The Black Swan: The Impact of the Highly Improbable. Taleb makes the case that there are three conditions of a black swan event. First, the event is highly improbable. Second, the event has tremendous impact, and third, that despite the low probability of the event happening, humans tend to concoct explanations for the event after the fact with the benefit of hindsight. In Taleb’s words:

“A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives. Ever since we left the Pleistocene, some ten millennia ago, the effect of these Black Swans has been increasing. It started accelerating during the industrial revolution, as the world grew more complex. Meanwhile, ordinary events, the ones we study and discuss and try to predict from reading the newspapers, have become increasingly inconsequential. Black Swan logic makes what you don’t know more relevant than what you do know.

Just imagine how little your understanding of the world on the eve of the events of 1914 would have helped you guess what was to happen next. How about the rise of Hitler and the subsequent war? How about the precipitous demise of the Soviet bloc? How about the rise of Islamic fundamentalism? How about the spread of the Internet? We act as though we are able to predict the future, or, even worse, as if we are able to change the course of history. We produce thirty-year projections of social security deficits and oil prices without realizing that we cannot even predict these for next summer.”

It’s interesting to note that Taleb’s book was published in 2007, on the eve of the financial crisis and just as the stock market reached an all-time high. Proving the point of his own book, this brilliant professor, researcher and trader writes nothing about the highly improbable but significant events that are right around the corner. At the time of his writing, he has no inkling that the US housing market is on the verge of collapse, that the stock market will fall 55% and that the world will enter the deepest economic downturn since the Great Depression. There is no mention of Lehman Brothers, subprime mortgages, zero-percent interest rates, quantitative easing, the TARP, AIG or Fannie Mae. Indeed, Black Swan, the bestseller, was silent about one of the biggest black swans of our lives.

Today we are obsessed with the election. Will it be Clinton or Trump? Taleb would argue that our intense focus on the election will turn out to be wasted energy. The endless polls, predictions, debates and news stories are trivial, day to day, ordinary events that are really inconsequential compared to the black swans that are coming our way. Yikes! Sounds a bit intimidating doesn’t it? What IS coming our way? Is it bad – war, disease, financial depression? Or good – rising prosperity, medical advances, technological breakthroughs, lasting peace? And what do I need to do to be prepared? Is my portfolio positioned correctly for the black swans of the future?

Here we turn to our long-time friends about which we often write: liquidity, diversification and discipline. Being prepared for an uncertain future means having adequate liquidity such as a reliable income stream or a robust bond portfolio to make it through difficult periods. Diversification means never bet the farm! For example, we don’t want all of our equity exposure in fossil fuels when the black swan breakthrough of a new battery-storage technology dramatically reduces the demand for oil. Now this doesn’t mean we abandon energy stocks, nor do we load the boat with investments in solar, wind and bio-mass start-ups. Discipline means we remain humble, we acknowledge that we can’t see the future and we rebalance the portfolio to maintain our liquidity and diversification.

Let’s go back to the farm! We had our own black swan occurrence last month. While Martha Kate took the news of the loss of the calf pretty hard, with the passage of time we all went back to our normal routines. A month passed and then we had our black swan event. It was the night before school started back and John’s family of six was just sitting down at their supper table for the final family meal of summer when one of the children jumped up and shouted, “Hey, some little brown animal is following Suzie around out there in the pasture!” The whole family bolted for the barnyard where they saw that the “little brown animal” was a new baby calf!

Just like that, the world changed… for the John Bragg family anyway. The chaos and stressfulness of getting four kids into the groove of a new school year (many of you can relate) was immediately complicated and compounded by the chaos and stressfulness of caring for a new baby calf. In consultation with neighbors possessing more experience with bovine care, John and Catherine learned that they needed to move quickly to get the flies off the cows’ backs with insect treatment, to partition the paddock to keep the goats and sheep away from the baby calf, to order some teat wash (available at discount prices on Amazon), and most important and also intimidating, to immediately begin milking Suzie twice each day and to continue doing so for the next four months so she wouldn’t develop mastitis which could be fatal. Whew! While it seemed a bit overwhelming at first, they did it all. Yes, they are still milking the cow twice each day. The extended family helped out some but really we just got in the way. As you might imagine, within five minutes of the discovery of the calf, all farm inhabitants (25 of us among three generations) were hanging over the fence trying to get a look. All of the children (and most of the adults too) have enjoyed trying their hand at milking under Martha Kate’s steady leadership.

In closing, whether black swans or white swans, we think it makes sense to be optimistic about the future. The human race has a fairly good track record of progress, especially when market forces are allowed to work. Just as my brother’s family scrambled around and figured out how to accommodate a new baby calf in the family, we’re optimistic that whatever swan shows up next, we’ll find a way forward.

Thank you for choosing Bragg for your planning and investing.