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By Guest Blogger Doug Rowat
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At the climax of the 1995 thriller Seven, the two hero detectives (played by Morgan Freeman and Brad Pitt) are about to face off with their serial-killer nemesis (Kevin Spacey) when the older detective wisely advises his protege, “If John Doe’s head splits open and a UFO should fly out, I want you to have expected it.”
Good advice for battling serial killers and good advice for dealing with market risk. Market risk will almost always manifest itself in entirely unexpected ways and investors should never be surprised by its randomness.
In late 2007, no one forecasted that Bear Stearns and Lehman Bros, two Wall Street behemoths that had been in business for 85 and 158 years, respectively, would both file for bankruptcy the following year. Nor did anyone forecast a US$700 billion bank bailout to prevent a complete collapse of the US financial system.
In late 2010, no one forecasted that a massive earthquake and tsunami would kill almost 20,000 people and devastate the Japanese coastline in early 2011. Global markets were already reeling in 2011 from the European sovereign debt crisis, but the earthquake and tsunami furthered the downside, and was, of course, a crushing blow to Japanese markets specifically. Global equities had a terrible year in 2011, but Japanese equities were down more than twice as much.
Ultimately, the Nikkei 225 finished the year lower by more than 17%.
In early 2020, no one forecasted a global pandemic that would not only cause a sudden and severe bear market but also a global recession. To date, more than 7 million people have died from Covid and the global economy, even now, still struggles with the inflation and debt that the pandemic contributed to.
The pandemic, in fact, prompted many investment firms to more broadly consider sources of market risk. In June 2020, for example, Deustche Bank contemplated the likelihood of a major solar flare disrupting markets. The last major solar flare occurred in 1859, so naturally Deutsche Bank’s risk forecasting was greeted with a fair bit of tongue-in-cheek skepticism. Here’s what MarketWatch had to say at the time:
Citing one study that assessed the odds of a major solar flare happening are 12% in a decade, that means there is a 40% chance it will take place in the next 40 years. Might want to keep a few spare batteries around.
However, Deutsche Bank’s risk forecasting was, in some ways, sensible; not because a major solar flare has actually occurred, of course; but because predicting unusual, even bizarre, events is as prudent an approach as any to anticipating what might actually affect markets. Downside risk rarely comes from the predictable places.
Neither does upside risk. And 2024 was a perfect example. In a year that featured not one, but two assassination attempts against the Republican presidential candidate, ongoing and escalating wars in Europe and The Middle East, the largest and most catastrophic IT outage ever, an S&P credit-rating downgrade of the world’s seventh largest economy (France), a surge in the gold price, a continuation of the longest 2- and 10-year US Treasury inverted yield curve in history, and a rise in global debt levels to a new record of more than US$320 trillion, one might have fairly expected 2024 to have been a terrible year for markets.
However, an improbable Magnificent 7 surge (who pegged Nvidia gaining 185% and eclipsing US3.3 trillion in market cap?) and a near-miraculous threading-of-the-needle soft-landing orchestrated by the global central banks, easily erased all these pesky concerns. The S&P 500 advanced more than 23% in 2024, capping its best back-to-back annual run since the late 1990s.
Amazingly, even Crowdstrike, the cause of that catastrophic IT outage mentioned above, was up by 39% last year!
And clearly the best minds in the business didn’t anticipate this upside risk. Here’s where the major Wall Street firms started the year with their 2024 S&P 500 targets versus where they were ultimately ended up. To say that their initial predictions underestimated the eventual S&P 500 gains would be a massive understatement:
Missed by a mile: Wall Street’s 2024 S&P 500 targets
Source: Bloomberg. Morgan Stanley’s latest target is for mid-2025.
But this is the nature of risk. Rarely are the events that will affect markets, either to the upside or the downside, readily foreseen. Risk comes from the periphery, out of left field, and develops in ways that no one sees coming. Even if we guess a risk event correctly in a general sense (Nvidia will have a strong year), chances are that we’ll still incorrectly forecast the magnitude of that risk (a 185% gain for Nvidia? Be serious.).
So, here’s my bold risk prediction for 2025: Trump’s head will split open and a SpaceX drone piloted by Elon Musk will fly out of it. Markets will plunge 25% in response.
This (probably) won’t happen; but if it does, I won’t be alarmed. This is how risk always works.
Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.
