With the S&P 500 near record highs, there are plenty of market risks to worry investors: A war in the Middle East that threatens to spin out of control and causes oil prices to spike, a contentious U.S. presidential election whose effects on markets are unknowable, and the recent interest rate cut by the Federal Reserve after years of inflation-fighting hikes. The list of uncertainties is adding to what many view as the fragility of the markets.
Mark Spitznagel, CEO of Universa Investments, has called the current environment “black swan territory,” a reference to the theory of market disruptions popularized by the book “The Black Swan: The Impact of the Highly Improbable.” Nassim Taleb, its author, is an advisor to Universa. In a recent Bloomberg interview, Taleb said the markets are more fragile than any time in the past 20 — or even 30 — years.
“We don't know what's going to be the thing that takes the market down in terms of what will be thought of as a narrative for starting a collapse. But we can say definitively that the market is susceptible to a collapse,” said Brandon Yarckin, chief operating officer of Universa.
“When we see this event, it has the potential to be as bad as the crash of ‘29, worse than 2008,” he predicted.
The reason, he said, is that “valuations are the highest they've ever been, which leaves the market susceptible to a crash as big as we've ever seen.”
Universa, which launched just before the financial crisis of 2008, now manages $18 billion selling so-called “tail risk” protection to institutional investors through managed accounts investing in options that are relatively inexpensive and pay off in the event of a crash. (A tail risk event is defined as a rare, unexpected, or extreme event that can be disastrous.)
For example, Universa made a killing in the early days of the pandemic in 2020 when the markets collapsed. During the first quarter of that year, Universa reported gains north of 4,000 percent.
But according to Yarckin, such outsize gains are not why the firm has become popular with institutional investors. “Certainly, people are drawn to high returns, but that's not what drew people to us or keeps them with us,” he said, acknowledging that Universa loses money when markets go up. “We’re here for crashes.”
Although Universa has been bullish since 2022, he said, the likelihood of crashes is tied to debt — and the amount of global debt is higher than ever. He added that the U.S. has just gone through the biggest-ever increase in interest rates “so the $600 trillion of debt that you were paying zero on, now all of a sudden you’re paying 5 percent.”
While rates are starting to ease, the debt overhang is a huge “albatross” around “businesses, governments and everything else,” he explained. The lag effects are yet to be felt. “The policy response tends to be very muted,” he said, arguing that the Fed was slow to go from tightening—which began about 18 months ago—to easing, which started in September.
Yarckin added that such easing typically signals a recession ahead. “The canary in the coal mine right now is the Fed cutting rates,” he said.
One potential black swan event could occur if a recession causes large swaths of people to quit contributing to their 401(k)s, said Michael Green, the chief strategist and portfolio manager at Simplify, a relatively young active ETF firm with $6 billion under management. Such retirement accounts represent a huge chunk of index funds.
Green explained that 95 cents of every investment dollar that now flows into a 401(k) goes into what are called target date funds, which have become the default for many people. Those funds, which systematically invest in a mix of stocks and bonds based on a retirement date, now account for $4.25 trillion, making them about 25 percent of the American retirement system. Overall, he estimated that passive investments represent about 45 percent of the market.
It is a huge change from the composition of the stock market during the last big crash in 2008, a trend that Green views as ominous.
“Historically we've thought about the market as discounting information, and it no longer does that,” he said. Investors who analyze a company’s prospects “have been replaced by machines that are simply saying, 'did you give me cash? If so, then buy.'” The passive funds buy in proportion to market capitalization, which he said means that “I buy more of stuff that went up since I bought last. And so that actually reinforces the momentum characteristics of the market.”
According to Green, “passive is really just the world's simplest algorithm.”
As money flows into index funds, markets rise, said Green, who argued that passive could account for the stock market’s ability over the past decade to bounce back quickly from downturns, as well as the market’s seeming lack of interest in fundamentals.
For the time being, there seems to be no stopping the juggernaut. Like Universa, Green is also still bullish. “Until things change, he says, “markets will continue to go up.”
“Every single day people are employed, they're making their contributions to their 401(k)s, and we continue to see a net positive flow,” explained Green. But, he cautioned, “If people lose their jobs and stop contributing to their 401Ks, the passive flows would deteriorate.” What would be more frightening, he said, is a scenario in which passive sells off for some reason, “then you actually end up with a distribution that has a wider left tail.”
The growing dominance of private markets could also prove to be a tail risk, according to Green. As the IPOs and other exit opportunities diminished for private equity-backed companies, managers didn’t have cash to give back to investors. Distributions from top managers were almost 50 percent lower last year than in 2019, according to calculations by Bloomberg. If the trend continues and pension funds or endowments need to raise cash, they could be forced to sell their liquid holdings, dragging public markets down.
For most investors, such scenarios may seem farfetched — and trying to hedge the risk is often too costly. Short selling, for example, has been largely unprofitable for years, and simply selling stocks deemed overvalued has largely seemed foolish.
“We had October 7th spilling into a slowly growing situation in the Middle East and yet markets have been up since 2022,” said Yarckin, mentioning one geopolitical risk that so far has had no impact on markets. “All of those things that we've experienced over the past two years, people have probably done things to protect themselves and they've been horribly expensive because [the markets] have gone straight up.”
Markets have become complacent, according to Taleb, who articulated another worry: The dollar could lose its status if investors in Asia and the Middle East fear confiscation of assets in the event of war, as happened with Russia when it invaded Ukraine. Said Taleb “These crises happen when you expect them the least.”
