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Hunting For The Next 'Black Swan'

Pundits have recently advised investors to bet on inflationary scenarios. However, investors might want to think twice before betting on pundits’ Black Swan forecasts.

Ken PosnerPundits have recently advised investors to bet on inflationary scenarios by shorting US treasuries and loading up on gold and other commodities. Their thesis is that growing levels of US government debt are fueling inflationary expectations, which will be further stoked when US banks redeploy excess liquidity back into lending. The pundits’ advice may turn out to be correct, only time will tell.

We live in a world of “Black Swan” surprises, some of which have been devastating to individual investors, and a descent into an inflationary (or hyper-inflationary) scenario for the US would be a shock. However, investors who want to avoid Black Swan losses might want to think twice before betting on pundits’ Black Swan forecasts.

A safer technique, borrowed from the discipline of fundamental research, is to “think probabilistically” across a range of scenarios before placing your bets.

Long associated with value investors like Warren Buffet and his mentors Benjamin Graham and David Dodd, fundamental research is more than financial statement analysis and valuation. At its heart, research is the study of causation, so that we can make predictions about companies, industries, or economic variables. Ignored by academics, fundamental research remains the primary method by which Wall Street analysts make investment decisions.

In the case of inflation and US interest rates, growing government debt and sidelined liquidity are indeed causative variables. But they’re not the only ones. For one, inflation tends to result from political division, which makes it difficult for a country to muster the will to repay its obligations. Political division was the cause of many historical inflationary episodes, as the US experience in the 1970s illustrates. Second, inflation is a relative game, just as are interest rates and currencies, and conditions in other countries matter, too. For example, during the 1930s, those countries that got off the gold standard the quickest recovered from deflation faster than their peers.

Fast forward to today, the US dollar has recently appreciated, not because the US economy is outperforming expectations, but rather over concerns about weakness in Greece, Ireland, Spain, and Portugal, which have raised questions about the future of the Euro. A stronger dollar could slow our economic recovery by making US exports more expensive, a blow to our manufacturers. This would take some pressure off the Fed to tighten rates, in which case, short-selling US Treasuries would produce losses, not gains.

As rancorous as it seems to us, our political system is stronger than those in many other places in the world – a possible reason why our currency might strengthen and inflation stay low, even while we manage higher-than-normal debt levels.

Consider China. Stephen Roach, chairman of Morgan Stanley Asia Ltd, warns of massive supply-side imbalances in China-centric developing Asia.

Continued stimulus funding and state-directed bank lending in China could lead to serious problems, and if China stumbles, the still-fragile global recovery would be at risk. Roach puts the probability of a global “double-dip” recession sometime in 2010 at 40 percent. A double dip could boost US treasuries not only because of slower-than-expected economic growth, but also because global uncertainty might lead to a “flight to quality” into US treasuries—a real problem if you are shorting them.

Causative variables also matter for commodities, for example, supply and demand. But for gold, supply and demand are less important causative factors than the psychology of goldbugs. If their enthusiasm sags, then gold could produce losses, too.

We’d all like to nail the next Black Swan, and placing all of your bets on inflation might seem like a tempting strategy to do so. But experienced traders know that in a world of extreme volatility, survival is the first priority. Don’t bet your whole portfolio on one strategy. Rather, consider allocating part of your portfolio to securities that would benefit from lower-than-expected interest rates and a persistent steep yield curve. Certain financial stocks might work. For example, take a look at mortgage REITs, currently trading at or below book value, some with double-digit dividend yields. Happy hunting.

Kenneth A. Posner is the author of the forthcoming “Stalking the Black Swan: Research & Decision-making in a World of Extreme Volatility.”