myICLUB Blog

In a 2002 news briefing, Secretary of Defense Donald Rumsfeld used the terms “known unknowns” and “unknown unknowns,” the former to refer to gaps in our knowledge that can be filled and the latter to refer information that we don’t know we don’t know.

Rumsfeld’s remarks were the subject of much commentary, some of it couched in ridicule and some backing up his cognitive framework. The comments even gave birth to the “Rumsfeld Matrix,” a framework that identifies four states of knowledge and the accompanying awareness or obliviousness of that knowledge.

The recent wildfire disaster in southern California is a perhaps a current-day example of an “unknown unknown.”

Surely, southern California residents have long been aware of the “known unknowns” of weather-related catastrophes that could affect them: earthquakes, Santa Ana windstorms, mudslides, occasional floods.

But the risk of a sweeping wildfire in suburban neighborhoods was rarely perceived as one worthy of attention. Wildfires are risks that might affect people who live in the forests and mountains of Northern California, the thinking went, but few people in the more populous and suburban cities in Southern California hardly needed to give a moment’s thought to the threat of widespread fires.

There are many elements of the stock market that fall beneath the heading of “known unknowns.” Investors are (or at least should be) aware of the many risks that come with investing in stocks.

Companies stumble and see their stock prices  plummet. Industries hit a rough patch and component companies falter. A recession arrives and economically-sensitive businesses see their fortunes decline.

Investors can’t foresee the exact circumstances of these events, but they can mitigate the downside b by diversifying holdings and actively managing their portfolios.

The entire stock market can be seen through the same lens. I like to remind investors that bear markets are never preceded by personal invitations. No one has ever been able to predict with anywhere close to 100% accuracy the near-term direction of the stock market the dawn of a bear market.

Throughout history, bear markets that drag down the market are predicated on a multitude of “known unknowns.”

While nearly all of these factors are commonplace and not completely predictable, most are foreseeable (though the timing is never known).

There are any number of “known unknowns” that theoretically could derail the current bull market. If enough of these turned south all at once, or any number of them performed exceptionally poorly, a market downturn could well be triggered.

Investors are well aware of these macro factors. Regulatory risks, global trade wars, industry-specific issues, interest rate cuts or raises, economic recession, and unchecked inflation are just a few of the talking points addressed thoroughly in the media.

But what about the “unknown unknowns?” These are the factors that investors and pundits don’t know that they don’t know.

Predatory lending to low-income home buyers with sub-prime mortgages coupled with a lack of regulatory oversight led to the 2007 collapse of the housing bubble and start of a global recession.

In 2008, markets were rocked by the failure of several major banks that had been considered “too big to fail.”

And the Covid pandemic in 2020 shut down economies around the world as the virus romped through every strata of society.

In hindsight, many of these events seemed like they should have been predictable. At the time, though, the risks around these issues were unknown.

As this issue of the SmallCap Informer was going to press, a new “unknown unknown” was roiling the markets. This time, the largest single-day market cap decline of any stock in history, as Nvidia fell 17% and shed $600 billion in a single day.

Other chip stocks and megacaps fell 15% to 20%  Chinese startup  DeepSeek claims to have developed an AI engine that is cheaper and more energy efficient to operate but can deliver results similar to those generated by other major AI players. No one, it seems, saw this coming.

This revelation was enough to throw a wrench into investor expectations that the Magnificent 7 and their kin would continue to invest in power generation, data centers, semiconductor evolution, and other investments to support a new era of computing.

One simple perhaps speculative announcement was all it took for investors to hit the panic button and dump shares. The next day, some of these stocks bounced back but most still remained below their previous highs.

The arrival of a new “unknown unknown” leads me to wonder about the current bull market.

What else might be lurking that could initiate an even more massive stock selloff?

What new “unknown unknown” will appear and send stocks sliding into correction territory or  into a full-blown bear market?

Of course, given the definition of “unknown unknown,” there are no answers to these questions.

Stock investors should resolve themselves to the notion that bear markets are unpredictable and unavoidable. As prevention is impossible, protection is the order of the day. Investors should focus on investing in high-quality businesses, diversifying their portfolios, and practice sound portfolio management.

Our focus stock in this issue is a return to a past pick that offers a clear picture of profitability in an expanding market.

Stay the course!

• DOUG GERLACH

Subscribers can read Doug's complete commentary and the in-depth profile of our recommended small company stock in the February 2025 issue of the SmallCap Informer stock newsletter. Not a subscriber? Subscribe to the SmallCap Informer and get monthly small company stock recommendations and updated buy/sell prices for each of the 45 high-quality small company stocks currently covered in the newsletter.