Is the Decline in the Stock Market a "Black Swan?"

Nassim Nicholas Taleb wrote a very challenging book called The Black Swan which tried to explain those big events in life that are unexpected. Taleb argues that three things create Black Swans - they need to be an outlier from prior experience, it has an extreme impact, and finally after the fact we try create explanations of the event that bring the event into greater predictability.

So the question is - are the financial meltdowns that we have had in the last several months a Black Swan? A student of mine asked me that in October and I immediately responded that I thought the answer to be no. I saw him a week or so ago and he asked me the same question again. It got me to think.

In the last decade we have had two events that might qualify as Black Swans - the tech bubble and this drop. The more I have thought about it the less I am inclined to describe either event as a Black Swan - although there are certainly more feathers in this episode than in the tech bubble.

Robert Schiller (who with a colleague developed the Schiller Case Index of home prices) wrote a book a couple of years ago called Irrational Exuberance that tried to explain how we get ourselves into speculative bubbles. He argued at the time that there were a number of disturbing trends in the financial markets that suggested that we were relying too much on unsustainable valuations. He points out in his most recent book on the Subprime situation that the financial services industry has grown from 2% of GDP to 7% since 1950. He also points out that the increasing integration of markets has produced both positive (for example, more capital available) and negative (for example,more volatility) effects.

It is hard for anyone to argue that they were able to pinpoint the decline - to predict it. Yet, in both of these financial disasters there were plenty of writers who were raising questions about valuations and the new models which everyone was seemingly accepting. In the tech bubble the models were based on the odd assumption that a company needed no money or business plan to succeed. In this meltdown the models were based in part on new ways to combine capital and some very sloppy valuations, including the way we qualified people for mortgages. One could make a very good argument that with those understandings that at least some did not find our current problems as a Black Swan.