Lessons of The Black Swan

This summer my wife, Ruth, gave me a book called The Black Swan. She told me it dealt with the business environment and suggested it could make for some interesting conversations with clients. I didn't know at the time that this book would play right into my next Peachtree Investment Quarterly.

According to the editor: "A Black Swan is a highly improbable event with the three principal characteristics: It is unpredictable; it carries a massive impact; and, after the fact, we concoct an explanation that makes it appear less random and more predictable, than it was." Sort of like what happened with the market meltdown.

These market problems did not occur overnight. For example, profit estimates have been declining for some time. At the end of June, analysts estimated profits of the S&P 500 companies at $109.83 per share. Those estimates had dropped to $108.26 by the end of July, and to $106.08 by the end of August. Today, economists at Merrill Lynch estimate S&P 500 profits at $60 a share for 2009.

There are some very big issues facing our economy. Our debt structure is too high. Household debt has gone up every month for the past 60 years except for the past two months. We are starting to see de-leveraging behavior set in. Entitlement programs (Medicare, Medicaid, unfunded retirement contributions) are too large.

Still, there can be little doubt that we are in a recession. And this is a worse-than-normal recession because it is induced not by inflation but by problems in the housing industry and the credit markets. Since 1855 there have been 32 business cycles, with the normal recession lasting around 18 months. According to the economists at Merrill Lynch, the earliest that this recession started was January 2008 and the latest was September 2008, so the market could start pulling out around February/March 2009 or the summer/fall of 2009, depending when we started the recession period. (This assumes that the government programs in place will turn things around and our economy will pull out of a recession within the traditional 18-month timeframe.)

It could be a rough ride until then. We know about the passage of the gigantic rescue bill and additional actions taken both in the United States and around the world. But these dramatic actions are designed only to fend off complete disaster by providing some easing of the credit markets. They do not directly address underlying problems in the housing industry or equity markets.

In addition, consumer confidence and consumer spending are taking a major hit, which will delay a rebound and could deepen the recession, since our economy is based so significantly on consumer spending. As Fed Chairman Ben Bernanke said the other day, "Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away."

Still, there are some positive signs. The U.S. composite index of leading indicators increased in September, the first increase in five months, according to preliminary estimates by the Conference Board. We have more than $3 trillion in money markets, and our federal government and the governments of other nations are working overtime to secure our financial future.

And there are still opportunities, even in this market. I believe that return on invested capital is the measure of true profitability of a company. There are companies with strong ROIC, and these are the companies I believe make the best sense, especially now.

There is no doubt that we are experiencing the kind of financial upheaval that occurs only once or twice in a lifetime -- a true Black Swan. It is disconcerting, even frightening, on an emotional level. But it is important to control our emotions and focus instead on our long-term goals and strategies -- and the lessons of history. We need to remember that we have faced financial crises before, and in every other instance the market has recovered and grown. There is no reason not to believe that will be the case again.

Garry K Schaefer
Atlanta, Georgia
October 7, 2009

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