Is the oil fall a black swan event?

Nassim Taleb describes a black swan as : A BLAC K SWA N is a highly improbable event with 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.

Lets look at Oil and check whether it fits the definition.

Was the steep fall in oil something that was predicted: No. I know of no study that suggested oil prices will fall and fall so steeply.

Is it something that shall have a massive impact elsewhere: Yes, oil is the main currency of many countries. While many are small, we do have a entire sub-continent in Middle East which depend on oil for most of their revenues. We also have Russia which has huge dependency on Oil to balance its budget.

While there is a direct benefit to countries such as India since we pay a lower price for oil, we will get impacted too as a large part of our foreign exchange earnings comes from Indians working in Middle East and repatriating a major part of their earnings. If that is impacted, it will have an impact on the Rupee – USD which in itself will then impact on a whole lot of other industries.

And finally, are we able to con-cot a explanation for the fall: Yep, blame the shale oil for the fall say the experts. Yes, a surge in production in US may indeed have had an impact, but why was that impact not a slower process than one we have seen.

Well before oil fell, Coal prices were falling at a pretty steep pace. But interestingly that was not seen as damaging (other than for countries such as Australia / Brazil among others). The question though is, was it a fore-bearer to the crisis that is coming?

Collateral damage is pretty hard to predict. Russia is going through a crisis that seems to show no signs of ending. In 1997, they defaulted on their own currency bonds and hell broke out in most markets though India being more closed was relatively safer. But if we were to see a repeat of something on that scale, what would be the probable impact?

Much of the rise in markets has been due to the continuous flow of funds by FII’s. How much of the funds are coming from countries (sovereign funds) or funds that have exposure to oil (directly or indirectly). Last week saw them selling though the net impact was +ve due to the sale of shares by Infosys promoters. If one removes that trade, net flow is -ve. If oil is really a positive to India, why are FII’s starting to pull out now?

One of the key reasons for the sudden crash in ASEAN countries was the over-leverage by corporates and countries since the currency rate being fixed, the assumption was that it was a zero risk venture. How many of our big caps have un-heged overseas exposure that may come back to haunt them in case Rupee takes a tumble?

Of course, all is not lost as of now. Nifty trailing four quarters PE is not exactly in bubble territory. But that said, we aren’t cheap and unless we grow, even these levels aren’t sustainable.

The last time we fell from a similar PE level was in 2004 and while we did recover, the Draw-down in that year was 30% from the peak. At current Nifty, that would mean a fall to 6000, something that was seen way before the “Acche din affect”.

In one of my earlier posts, I had provided the future returns based on current Nifty PE and at 21.5 (where we were a few days ago), we were coming close to a point where we had a average gain of a few percentage points over the next three years.

I don’t believe that the way forward is by trying to predict, especially using macro views. After all, the housing bubble that was the reason for 2008 began not in 2007 but in 2005 and by 2006, it was seen as spreading like a wild weed. Markets take their own sweet time to react to events and it makes zero sense to try and trade on that. Instead, what we need is a plan, a plan on what will one do if our portfolio drops X% and what they shall do when it drops X-10%.

Every crisis is a opportunity if only you can survive the crisis in the first place. Opportunities come once in a while and only early preparation can help one not only to tide over the crisis but take advantage of the same. So, write down your plan and more importantly, stick to it.