Over the past decade, the term “black swan” has gotten heavy play in the financial press. The term comes from a book called “The Black Swan: The Impact of the Highly Improbable” by Nassim Taleb.

As Taleb defines it in his book, a black swan is a rare and extreme event that can’t be predicted in advance. Because the book was published in 2007 — just prior to the global financial crisis of 2008 — the term “black swan” gained worldwide recognition as shorthand for describing an outlier crisis event.

It is very hard, if not impossible, to guard against a true black swan as Taleb defines it. That is because a true black swan is, by definition, an event that nobody can see coming.

With respect to market dangers, black swans are actually quite rare. The financial press throws around black swan terminology far more often than it should — a habit Taleb has vocally lamented over the years — using the label in a sloppy or misapplied manner, calling things black swans that aren’t.

What the financial press fails to realize is this: A crisis event or asset price meltdown that telegraphs danger signs in advance is not a black swan. It’s actually a gray rhino.

The bad news is that, unlike the genuinely rare black swan, gray rhinos are a far more common occurrence in markets. The good news is, you can guard against gray rhino risks in your portfolio.

The term “gray rhino” is not well known in the West. But it has caught on in China. President Xi Jinping has referred to gray rhino dangers in public speeches, and Wang Jingwu, the financial stability chief for China’s central bank, has publicly cited gray rhino scenarios the central bank is monitoring.

The gray rhino was introduced as a concept by Michele Wucker, an American author and policy analyst, at the World Economic Forum in Davos in 2013. Three years later, in 2016, Wucker published a book titled “The Gray Rhino: How to Recognize and Act on the Obvious Dangers We Ignore.”

Here is Wucker describing the difference between black swans and gray rhinos:

“The black swan lends itself to the idea that we don’t have power over our futures. And unfortunately, the less control that we think we have, the more likely we are to downplay it or ignore it entirely. And this dangerous dynamic masks another problem: that most of the problems that we’re facing are so probable and obvious, they’re things that we can see, but we still don’t do anything about.”

“So, I created the gray rhino metaphor to meet what I felt was an urgent need. To help us to take a fresh look, with the same passion that people had for the black swan, but this time, for the things that were highly obvious, highly probable, but still neglected. Those are the gray rhinos.”

A gray rhino is something you can see coming — but only if you pay attention. This helps explain some of the confusion in the financial press. To someone caught completely by surprise, a crisis event might be considered a black swan. But if they should have seen it coming, it was actually a gray rhino.

There is a powerful gray rhino example that recently hit the news. On Aug. 12, Argentina’s stock, bond, and currency markets saw one of the worst meltdowns of all time, with the Argentine stock market’s 48% one-day collapse outpacing all other market collapses but one since 1950.

The collapse was a result of surprising political news. Investors were shocked by the strong showing of populist Peronist candidates in Argentina’s primary elections.

If the Peronists win the Argentina election in October, a much more likely event now, that increases the odds Argentina will default on its sovereign debt for the ninth time since 1816.

As a result of the collapse in Argentine stocks, bonds, and currencies, many emerging market money managers were crushed. Michael Hasenstab, the manager of the Franklin Templeton family of bond funds, lost an incredible $1.8 billion in a single day on his aggressive Argentine bond position.

Money managers burned by Argentina’s sudden price collapse across currency, stock, and bond markets had natural incentive to say: “Nobody could have seen it coming! That was a black swan!”

But for bond managers in particular, the black swan defense (as an excuse for their losses) is ludicrous. To understand this, all you have to do is look at Argentina’s sovereign debt track record:

  • As the Financial Times reports, Argentina has defaulted eight times since 1816.
  • There are now serious fears Argentina could default for a ninth time.
  • Eight defaults over a 203-year period averages a new default every 25.4 years.
  • If they default a ninth time, the average shortens to once every 22.6 years.

You would think that, if a country had a habit of defaulting on its sovereign debts every 23 years or so, like clockwork for more than two centuries, investors would be wary of lending money to that country.

And yet, Argentina successfully issued $2.75 billion worth of 100-year “century bonds” in 2017. They were dubbed century bonds because, given the 100-year maturity rate, Argentina theoretically would not have to pay back the full principal for a century.

In 2001, Argentina defaulted on $100 billion worth of debt. The country then spent the next 10 years fighting with investors over whether it would pay anything back on that debt.

And yet, just six years later, investors showed new willingness to lend billions to Argentina — for 100 years! Argentina’s “century bonds” were a huge gray rhino from their moment of issuance in 2017. Now, just two years later, they are teetering on the brink of disaster.

No reasonable person would lend large sums of money to a person, or a country, who has already gone bankrupt eight times, with all of the habits still in place for creating a ninth bankruptcy event. And yet, with Argentina, it happened. Some investors, like Hasenstab, did it in huge size.

The reality is, investors and money managers do stuff like this all the time — not just in bonds, but stocks too, with names like Enron and Valeant and General Electric. They take big risks where an obvious gray rhino should have been detected. And then they falsely yell “Black Swan!” when something blows up.

It’s important to watch out for gray rhinos in your portfolio because, if you don’t do it yourself, the odds are high that nobody else will. Money managers and pundits have an incentive to ignore gray rhinos.

For every deeply risky investment situation, there is a likely money manager or Wall Street analyst out there — perhaps many of them — trying to make a name for themselves as a contrarian bull on that particular investment. Their risk-reward ratio for doing this is asymmetric in favor of reward: If the bullish calls works out, they do the rounds of the financial press and collect the glory. If it doesn’t, they move on.

In the context of a real investment portfolio, however, the risks are far greater, as getting trampled by a gray rhino can be devastating. When a small investor puts a large portion of their portfolio into a stock or a bond that is declining in price, and then continues to hold the position or even add to it as the rhino tramples them, a significant portion of their retirement wealth can wind up getting destroyed.

One simple way to guard against gray rhinos is to maintain awareness of price behavior. If a stock or a currency or an ETF is not behaving properly in terms of price action, that can be a sign of hidden danger.

This is not about modest fluctuations in price. Asset prices move up and down all the time, and healthy trends need to “breathe” in terms of sometimes having a correction before continuing higher.

But when an asset, like a stock or a bond, sees its price break important long-term trend levels, and transitions from a long-term uptrend to a sideways trend or downtrend, this is a warning. It isn’t a guarantee that something is wrong. But it functions like a bright red flag.

And if evidence of worrisome price behavior comes with clear balance sheet problems or issues in the news, or deteriorating earnings as reported on quarterly calls, a gray rhino may be lurking.

Along with many other ways of being helpful, investment software can help you monitor for “gray rhinos” in your portfolio. Your first line of defense in TradeStops is the Stock State Indicator (SSI), which literally tells you the current state of a stock in relation to its primary trend.

If the SSI is green, that means the trend is healthy — no gray rhino detection on the price front. If the SSI is yellow, it is like a blinking “caution” light.

And if the SSI is red, that is either a major warning sign or a potential signal to exit the investment, depending on the rules you use to manage your portfolio.

So, don’t fall victim to gray rhinos. With a little patience and observation, and the help of easy-to-use investment software, you can often detect them and sidestep them. Your retirement will thank you for it.

Keith Kaplan
CEO, TradeSmith