Investment strategist Ed Yardeni identifies several events that could radically change our financial lives. By Anne Kates Smith, Executive Editor February 2, 2010 It’s a tradition on Wall Street to offer predictions early in the year about where the economy is headed, whether companies will prosper and what will happen in the stock market. Here, Dr. Ed Yardeni, president of Yardeni Research, Inc., a New York-based firm providing independent investment strategy research, tries to spot 2010’s “black swans” -- those rare and unexpected events that can change the course of history, or at least have an outsize effect on your portfolio. KIPLINGER'S: What are black swans, and why are they important for investors? YARDENI: Black swans are events that are not forecastable -- they’re surprises. Most of us live our daily lives pretty close to the mean distribution of experiences; in other words, we wake up in morning, go to sleep at night, and events in between are fairly predictable and recur the next day. But every now and then, we get an event that’s a complete and total surprise. Black swans aren't necessarily bad. They can be bearish or bullish. But they’re extreme, and by their nature, hard to predict. That doesn’t mean we shouldn’t give it a try. As investors, we have to think about extreme scenarios. Sometimes, black swans start to appear off in the distance. It’s important to see them early, and to try to assess whether they have the potential to radically change our financial lives. For example, early in 2007 we started to get news that there was trouble in the subprime-mortgage market. Yet few people appreciated the consequences that would play out in 2008 and 2009. That was a black swan. Advertisement Do you see any black swans on the horizon for 2010? Right now, on the negative side, there are certainly discernable black swans -- events that are worrisome, especially if they continue to worsen. Clearly, the housing market remains the weak link in the economy. It's been supported by tax credits and by the Federal Reserve’s efforts to keep rates down. But there are still plenty of people with negative equity in their homes. Foreclosures may continue to rise. Also, the Fed has made it clear it will stop buying mortgage-backed securities at the end of March. By then it will have bought $1.5 trillion worth of securities since the beginning of last year. When it stops, that could put upward pressure on mortgage rates and weaken housing activity. Another issue here at home is the outlook for consumer spending, which obviously is related to labor markets. The black-swan event -- which people are already worried about even though it’s supposed to be a surprise -- is that the labor market will remain difficult, with unemployment remaining very high, and that that will depress consumer spending. Both of these concerns bear on the potential for a second dip in the economy. Advertisement I think that we’re relieved after our near-death experience early last year, when it looked as though we came awfully close to a financial meltdown and depression. We feel that we dodged that depression bullet. But a black-swan event would be that we have a depression anyway. It’s important to remember that the Great Depression was actually two great recessions, in the early 1930s and again in the late 1930s -- we could still get into trouble here. If we fall into recession again soon, we might look back on this entire period and describe it as the second Great Depression. Are there any swans swimming in the currency markets? There’s been a lot of talk about the dollar crashing and bond yields soaring to defend it. That looks less likely. There’s a growing recognition that the dollar is the best of a dodgy breed of currencies. There’s a greater risk that the yen, the pound or the euro would take a dive before the U.S. dollar does so. The negative black swan could be a major decline in any of these four important currencies as a result of so-called sovereign debt issues -- which just means they’re selling too much debt because they have such high deficits. What about the so-called PIIGS -- Portugal, Italy, Ireland, Greece and Spain? Advertisement There’s definitely the potential for a currency crisis. Greece is making all the headlines but the others are certainly in line for problems. They all have somewhat different profiles, but what they have in common is that they’re borrowing too much -- they have too much debt outstanding and need to borrow more. The worst case black-swan scenario would be the collapse of the euro, as relatively strong economies, such as France and Germany, refuse to support the weak economies that continue to borrow too much. A euro currency crisis looks to be a plausible black swan -- much more so than the collapse of the dollar. What else worries you? China could be another black swan. This is the first global recovery led by China, and China clearly matters a great deal to the global economic outlook. There’ve been some recent jitters because China, over a very short period of time -- just one year -- has inflated a big real estate bubble, just as we did over a few years not too long ago. The Chinese authorities are already moving to take the air out of that bubble by restricting credit, but history shows that it’s hard to take the air out of bubbles -- they usually just burst. If that happens and the Chinese economy gets noticeably weaker, that will be bad news for the global economy and for stock markets around the world. That wouldn’t be much of a surprise -- sometimes you can see swans off in the horizon. It’s like the Alfred Hitchcock movie The Birds. You see one, two, then all of a sudden they’re all over and they’re attacking. Pretty scary. Are there any black swans on the positive side of the ledger? Advertisement The biggest surprise would be if the stock market ends the year at a new high. That would blow everybody’s socks off. That’s the most positive black swan out there. The most likely positive scenario is that the economy surprises to the upside -- that the recovery is normal or better than normal, led by a cycle of improving corporate profits. If profits continue to improve as they have the past four quarters, then companies will start to get more optimistic, decide to expand, hire more workers again and engage in capital spending. That could happen on a global basis. The global recovery could turn into a boom, and that would be extremely bullish for stock markets. Is that what you believe? I'm arguing that the recovery is not going to be radically different this time. Yes, there are plenty of black swans out there, but I believe that a fairly traditional business and investment cycle will prevail. That’s why I’m giving a 70% probability to the happy scenario -- that economic growth continues better than expected, unemployment subsides and inflation remains subdued, while the dollar rallies and stocks and corporate profits are stronger than expected. But haven’t we had a good run already? The market’s up 70% from its March 2009 low. Yes, but the market’s price-earnings ratio based on analysts’ expectations of corporate earnings is a modest 14 to 15. Earnings have had a strong rebound. So far, you could say that we’ve had a relief rally. If earnings continue to improve, the market should move higher, and there’s no reason earnings shouldn’t continue to improve. The current earnings cycle is the fourth quarter in a row with lots of positive earnings surprises.