Some Black Swans Are 100% Predictable

03/28/2011 1:01 pm EST

Focus: GLOBAL

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Investing in authoritarian countries can be highly lucrative, but beware the inevitable blowback, writes Nicholas Vardy in Global Stock Investor.

The Vienna-based Democracy Ranking Association combines ratings from Freedom House (right wing) with the Human Development Index of the United Nations Development Program (left wing), thereby offering a reasonable, balanced consensus of the world’s top democracies.

Here are the results, along with the ETFs that will allow you to invest in them:

Vardy Chart

The Nordic countries (Norway, Sweden, Finland, and Denmark), as well as Switzerland, stand at the head of the association’s ratings. New Zealand, the Netherlands, Ireland, Germany and the United Kingdom also boast very high scores.

Seven of the Top 10 countries are in the European Union. This includes Germany, which offers an encouraging example of how history’s problem children can transform into stable democracies in the blink of an historical eye.

All of the classical English-speaking countries—the United Kingdom, the United States, Canada, Ireland, Australia and New Zealand—rank within the Top 15, with the US squeaking in at No. 15 in the latest rankings.

The list offers few surprises. Overall, it turns out that democracies correlate highly to prosperity and standard of living. Their socialist reputation notwithstanding, it’s unlikely that you’ll ever hear that Swedes have just stormed the ramparts of their Parliament, overthrowing the government.

And as the late motivational speaker Jim Rohn observed, which Florida resident ever risked his life on a homemade raft to escape to Cuba?

Autocracies: Big Profits or Black Swans?
Here’s the irony. Their political stability notwithstanding, prosperous democracies rarely seem to offer the most exciting investment opportunities. After all, the Pakistani market rose by 449% over the past decade. The Egyptian market rose by 430% over the same period, while the S&P 500 rose by a mere 2%.

Therein lies the conundrum.

On the one hand, the Pakistans and Egypts of the world offer huge investment returns. On the other hand, 430% gains in Egypt mean little once a revolution breaks out.

Here’s my answer: Egypt—like many other autocracies—is a “black swan” market. Popularized by Nassim Nicholas Taleb in the bestseller of the same name, a “black swan” is an event that is unexpected in the normal course of things, and difficult to predict.

Equally importantly, once black-swan events happen, they are the only things that really matter.

Egyptian dictator Hosni Mubarak’s fate was much like that of Taleb’s parable of the Thanksgiving turkey: A turkey is fed for 1,000 straight days. It is happy, plump, and fat—and has every reason to expect that the next 1,000 days will be the same as the last 1,000.

But then Thanksgiving rolls around. Suddenly—and unexpectedly—it gets its head cut off.

Next: The Biggest “Black Swan” to Worry About

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China: The Biggest Black Swan?...
Autocracies always appear rock solid. Soviet presidents hung on to power for 60 years.

And autocracies’ outward achievements always are impressive. The Soviets launched Sputnik; they became one of the world’s two military superpowers; and their Olympic athletes trounced the world’s best. The Soviet economy was once set to overtake the US economy by the Orwellian year of 1984.

But stability in autocracies is always an illusion. Tensions are never far beneath the surface. And once autocracies implode, they do so in spectacular fashion.

Democracies are messier, day to day. But in many ways, that messiness is an escape valve for freedom of expression. A commitment to free speech, fair elections and property means that democracies are remarkably stable.

Whether you’re a fan of Glenn Beck or Keith Olbermann, neither one ever urged his fans to storm and set fire to the White House. Instead, they urge you to get out and vote. Stable democracies are never overthrown by revolution. Autocracies always are.

Today’s version of the Soviet Union is China. Shiny skyscrapers notwithstanding, China is still run by an authoritarian Communist Party.

The former China correspondent of the Financial Times once told me that, by his calculations, all but 300 of the 11,700 businesspeople with fortunes of $20 million or more in China are Communist Party cronies.

That China will overtake the United States is today’s conventional wisdom. Whether their “1984” moment will arrive by 2025 or 2040 is just a matter of a 26-year-old Goldman Sachs analyst plugging the right numbers into her spreadsheet.

...Or Predictable “White Swan”?
Of course, that Goldman Sachs analyst suffers from the same bias as the turkey. She assumes the next 1,000 days will be like the last 1,000. But if you look at the Democracy Rankings, the coming “Black Swan” event in China is really a predictable “White Swan”—more a matter of “when” and not “if.”

Its outstanding stock-market returns notwithstanding, Egypt never made it into the top 100. Not a single Arab country ranks in the top 75. China chimes in at 97.

China bulls will argue until they are blue in the face that “China is different.” Japan bulls did the same 25 years ago. But as John Templeton observed, whenever someone says, “This time it’s different,” it’s a sign for investors to run the other way.

Viewed through the prism of democracy, the events in Tunisia, Egypt and Libya are just the beginning. Wealthy autocracies like Saudi Arabia, Dubai and even China will do their best to cajole or bribe their populations into submission—or try to bomb dissenters into smithereens, as Gaddafi is doing.

The irony is that by educating their populaces, Chinese and Middle Eastern autocracies are sowing the seed of their own destruction. Develop a population of smart, educated young people, then fail to give them jobs and opportunities, and you have the makings of a revolution.

You’d be hard-pressed to find a more accurate prediction.

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