2022 Mid-Year Commentary: The Beauty of Black Swans

For those that may not remember, this was the year that the Boston Red Sox ended the Curse of the Bambino by sweeping the Cardinals to win their first World Series championship in 86 years. Of course I was devastated, but the events leading up to that historical moment were almost more impressive than the victory itself. After blowing a three-game lead in the 2003 American League Championship Series (ALCS) against the New York Yankees, the Red Sox found themselves in the opposite situation just one year later – down three games to zero in the 2004 ALCS against the same scrappy rival. While most viewers assumed that Bambino’s curse may never be broken, the Red Sox refused to concede – ultimately defeating the Yankees and sweeping the Cardinals (via eight consecutive wins) to earn their first World Series title in nearly a century. This was the first time in MLB history that a team had ever come back from a 0-3 series deficit – the probability of which stood at a mere 2.5% going into game four of the 2004 ALCS. Overcoming 39-1 odds is nearly impossible by every stretch of the imagination, but when you combine patience and discipline with an intense focus on fundamentals – a grim outlook can all of a sudden turn into opportunity. This is the reality that we find ourselves in today.

Thus far, 2022 has been characterized by fear and uncertainty that has since translated into a historically volatile start to the year. U.S. equities suffered their worst first half of the year since 1970, with the S&P 500 down more than 20% and the Nasdaq-100 down nearly 30% as of June 30th. Worse yet, skyrocketing interest rates sent the U.S. Aggregate Bond Index (AGG) and long-dated U.S. Treasury Bonds (TLT) down by more than 10% and 20%, respectively. But even more interesting is the uniqueness of this year’s market volatility – a slow, yet painful churn resulting in significant losses with relatively muted volatility. In fact, the first half of this year was a 1st percentile event with the S&P 500 down more than 20% and realized volatility capped at 25% – roughly half the volatility of a typical market selloff. While this market environment may seem like a statistical anomaly, it’s been a very real and emotionally-taxing experience for investors far and wide.

This lends itself to a rather lethal cocktail for investors relying on some combination of equities and fixed income to generate a stable source of total return – not to mention the behavioral difficulty in sticking with an investment strategy that’s burning from both ends. We’ve written at length about the limitations of traditional public market portfolios and how rising interest rates, lofty equity multiples, and mega-cap tech concentration were bound to collide at some point. We argued in our 2021 year-end commentary that this would likely be driven by inflationary pressures and subsequent monetary policy tightening – the combination of which would not only serve as a headwind to equities, but also be detrimental to investors relying solely on cash and fixed income for capital preservation. In doing so, we outlined our approach to navigating equity markets and discussed the importance of emphasizing smaller companies with greater profitability and lower valuation multiples in the current environment. We then reiterated these findings in our May commentary and outlined some of the alternative risk-managing tools we were using in lieu of fixed income – including liquid instruments such as managed futures, as well as illiquid instruments such as real estate and private credit. This is not to suggest that we attempted to time the market, but instead relied on decades of academic research to identify similar regimes from the past and strategies that worked well during those environments – particularly those that follow a systematic, rules-based process.

Emphasizing profitability and value within equities is always a good practice, but this year has made for an especially strong case study as less profitable, growth-oriented companies have been hit asymmetrically hard by the selloff – sending companies like Meta, PayPal, and Peloton down by more than 50% year-to-date. This allows us to invest confidently in equity markets despite the overwhelming sense of negativity that defines a bear market, but equities aside – how does one preserve capital in an environment where cash is hemorrhaging value due to inflation and fixed income is declining in lockstep with equities? This is our case for alternatives, and the below chart offers a pretty compelling visual of the 1st percentile reality we’re living in:

The dark blue line represents the S&P 500, the yellow line represents long-dated U.S. Treasury Bonds, and the light blue line represents one of the managed futures funds we’ve been introducing in client portfolios. As you can see, U.S. Treasuries served as a ballast during the two most recent market selloffs in Q4 2018 and Q1 2020 – resulting in a painful, yet relatively manageable experience for most investors holding a traditional basket of equities and fixed income. This year, however, empirical correlations began to erode and fixed income no longer served as the mitigant that it had in prior market selloffs. In fact, long-dated U.S. Treasuries – a risk-off instrument traditionally viewed as an equity hedge – has lost nearly as much value as the S&P 500 year-to-date. Then enters alternative investments such as managed futures – a systematic, quant-based strategy that can take long and short positions in traditional assets such as equity and fixed income, as well as less traditional assets such as commodities and currencies. Herein lies the value of alternative investments: the ability to access non-traditional, uncorrelated assets via well-governed, rules-based processes. Some investors may deem these approaches confusing and unnecessarily complex, but having access to alternative markets can be incredibly valuable in portfolio construction – especially when you’re in the midst of a 1st percentile event and nothing else is working. Of course this is just one example of the many alternative investments we’ve embraced, but a compelling one nonetheless.

So that begs the question – what does one do when they find themselves in an unprecedented, statistically unimaginable market environment? Every market selloff is unique in its own way, and though we often draw comparisons to historical timeframes – unpredictability is the only commonality in a bear market environment. Leveraging historical data when making investment decisions can be helpful, but the biggest shortcoming is that any market selloff is by nature a statistical anomaly – that’s why they call it a black swan event. What’s a black swan event you might ask? The term actually originated in 1697 when a Dutch explorer discovered black swans for the first time off the coast of Australia. It was widely believed that only white swans existed, but the unexpected and rather profound discovery of black swans changed zoological theories thereafter. The term was later applied to financial markets when mathematician Nassim Nicholas Taleb published a book titled The Black Swan – where he examined the rare and profoundly impactful events that frequently occur in society. He discovered that not only were these events unpredictable and rare, but that people often had simplistic explanations about the events after the fact – almost as if the events were predictable in the first place. This tendency to view the past through a lens of predictability is referred to as hindsight bias, which can be quite dangerous during volatile market environments because it often results in overconfidence bias – ultimately leading to an illusion of knowledge and/or an illusion of control that can result in costly mistakes. Take for example your friend or neighbor that ‘had a hunch’ that the market would selloff and is now offering opinions and even advice on all things investing. Sound familiar?

Investors often think that they can time the market – especially during periods of pronounced volatility (i.e., black swan events). But unless you’re Marty McFly and happen to have access to a DeLorean, then attempting to predict the future (and thus time the market) is a failing strategy. So that being said, what might we reasonably expect out of the market given where we are today? Although we find ourselves in an incredibly unique environment, we can take some comfort in the fact that equities tend to perform decently well during periods of rising interest rates and decelerating growth. Does this mean we’ll see an 8% return on the S&P 500 over the next 12 months as shown below? Perhaps, but it’s certainly not guaranteed. Historical data has its limitations, but it can be useful when making informed decisions about potential future outcomes – especially if we then follow a process to filter out the noise and remain disciplined.

Average 12-Month S&P 500 Return since 1975 (%)
Real 10-Year Treasury Yield
US Real GDP	Falling	Stable	Rising
Accelerating	19	16	19
Unchanging	14	15	12
Decelerating but growing	13	9	8
Decelerating and contracting	-3	-20	-19

Source: Goldman Sachs

So are we in the midst of a black swan event? Perhaps. If so, to what extent can we rely on history to make informed decisions about the current market environment? It’s difficult to say, but if there’s one thing that history has shown us – it’s to be patient and disciplined with a keen attention to detail, the product of which can translate a grim outlook into opportunity. Black swan events present investors with a tremendous opportunity for future return, but it requires equal parts discipline and opportunism to make it a reality. The easiest way to remain disciplined is to follow a process, and that’s exactly why we use systematic, rules-based managers when navigating historically unique market environments – it doesn’t necessarily avoid all the potholes, but it certainly makes for a smoother ride. So as we find ourselves in a 1st percentile market environment, let us not be discouraged by a historically volatile start to the year – but instead motivated by the opportunities that lie ahead. The future can’t be predicted, but it can certainly be navigated – and if there’s one thing we can learn from the Red Sox – it’s that patience and discipline can overcome even the most dire of circumstances.

About the Author

Dean Rogers, CFA

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