Storms and Stocks: Dealing with Disruptive Shocks

Sandy, the super-storm that terrorized New York and its environs is now history, but it left a trail of destruction. As communities around the city and New Jersey dealt with power failures, gas shortage and transportation chaos, I was thinking about the lessons that I learned from the experience and their application to financial markets, which have been buffeted with their own storms for the last five years.

1. Once is an accident, twice is bad luck, but three times is a pattern: For much of the time that I have lived in the United States, power failures were not only unusual but when they did occur, lasted at most for a few hours. However, in 2011, we lost power for several days twice, once after Hurricane Irene and once after a freak ice storm, and this year, we lost power again for a week. While it is entirely possible to attribute these occurrences to chance, it is also possible that weather systems have changed and that the last two years may be more the rule than the exception going forward. The last five years in financial markets have been characterized by “unusual” macro events (banking crisis, Greece, Spain etc.) but they are unusual only because we are viewing them through the lens of recent history (the prior six decades in developed markets). As with the weather, it is possible (and I think it is likely) that these macro crises are not an aberration but are part and parcel of markets for the foreseeable future, and that investment strategies and risk management systems have to be adapted accordingly.  
2. History provides little guidance: When there is a disruptive shock (and the storm definitely qualified), it is human nature to use past history to fill in the gaps, even if it does not quite fit. Thus, my neighbors argued that since train service was up and running a couple of days after the storm last year or the terrorist attacks in 9/11, it was likely to be back up after this one too. In financial markets, investors have used the crutch of historical data (equity risk premiums from the past, PE ratios over time) to evaluate when and where to invest these last five years. In both cases, extrapolating the past would have yielded poor predictions. 
3. Misinformation fills the news vacuum: In the immediate aftermath of the storm, there was an information vacuum where the power and transportation companies had no useful guidance to customers and rumors filled in the gap. With each macro crisis over the last few years, we have seen the same phenomenon in markets, where rumors of deals made and unmade have moved markets substantially. 
4. It is good to have back up systems: About 15 months ago, none of the houses in my neighborhood had back-up generators, as the cost of installing one seemed to be well in excess of any potential benefits. After this storm, I would not be surprised to hear generators starting up at a third of the houses the next time we lose power. The problem, though, is that these generators are themselves dependent upon fuel (natural gas or gasoline) to work and may end up being idle in their absence. Risk managers (at companies and financial service firms) have devised their own back up systems to protect themselves against the “last” crisis but these systems may themselves break down, in the face of the next crisis. 
5. But it is better to design resilient systems: One reason that this portion of the East Coast was hit so hard by the storm was that it was never designed to withstand it. In particular, large power-dependent houses with finished basements, power stations that are close to the ocean or rivers and overhead power lines are all rich targets for storms like Sandy. If these storms are the new norm, we have to think about building houses that are livable without power (those older houses have lower ceilings, unfinished basements and fireplaces for a reason) and a more defensible power system. In investing we have to think about a similar redesign of how we invest, with dynamic asset allocation (reflecting the constant shifts in the macro environment) and a stock selection process that is less dependent upon rules of thumb (many of which were constructed for a past that no longer applies). 

More generally, in the face of the increasing frequency of disruptive shocks, I would pick:

(a)Simpler over more complex systems: Over the last few decades, lulled by the growth of technology and access to data, we have built more and more complex systems (in both day-to-day living and investing) that are dependent upon both. Since disruptive shocks cut off both technology and data, simpler systems will survive and bounce back faster in the face of these shocks. I am glad that my investing strategy is based on intrinsic valuation and that I can value a company with an annual report and a calculator (or even an abacus) and that I am not dependent on access to real time data or computerized trading for investments. I am even happier that I could go two weeks without tracking either the market or looking at the investments in my portfolio, without fear of a meltdown. 

(b) Decentralized over centralized systems: The “hub and spoke” system, where you centralize resources does have its advantages, primarily related to efficiency, at least in normal times. The problem with these systems is that failures at the system’s center can shut the entire system down, as passengers on United and Delta discovered, when their hubs (Newark for United and LaGuardia for Delta) shut down during the storm. Decentralizing these systems may create more coordination headaches during normal time periods but allow for faster recovery after disruption.

I am glad that the storm has passed, that I have power and that I am able to type this post on my train ride home from work. At the same time, I realize that as an investor, there are more storms coming, both from within (the fiscal cliff) and from outside (Asia’s slowdown and the EU’s future) and that I need to become more agile to weather these storms. Time to get to work….