Thursday, November 15, 2012

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….

8 comments:

Tom said...

There's a great piece on some lessons learned from Sandy, what worked and what didn't, by way of consumer-grade backup and resiliency: http://intheboombox.tv/lessons-from-sandy-getting-ready-for-the-next-time-emergency-preparedness/

Anonymous said...

Apologies to go on a tangent, but can't resist:
Whats your take on the small storm being unleashed on apple's stock. Has anything changed fundamentally for that company or is it just that it's price is now subject to the whims of a different investor class (dividend seeking) that made you exit the stock early this year ?

Anonymous said...

What do you refer about descentralize in investing? Can you put a instance?

Jason DaCruz said...

Great post -

I heard someone say "the important events of the world, the ones that produce the most valuable lessons, have and will continue to occur while you're dead." That may be a depressing thought, but that doesn't make it wrong.

Learning about the practice and theory of finance is necessary but not sufficient. I have to disagree with you: history can help to get us out of our comfort zone and reconsider what we find "ordinary." As Mark Twain said, "history doesn't repeat itself, but it tends to rhyme." Sure, historical analysis will leave us with some uncertainty, but this is finance after all!

As an aside, the changing macro picture may be part of a larger deleveraging of the west; a mix of austerity and inflation that will bring the developed world closer to purchasing power parity with the rest. Isn't that what economic theory would predict over the ill-defined "long term?"

Imajumo said...

The macro issues seem to have a single cause so to the extent that there is a different way to properly invest in a delevering world, that makes sense.

On simple vs complex, it's an elegant thought but could one make a case that as our complex systems develop (perhaps becoming more complex in the process), they become incresingly robust? The MTA, power grid, etc are all artifacts of infrastructure originally planned decades ago. Even so, I might posit that with all the blackouts and what not, we were still better off than if we had no power or communications infrastructure at all. How quickly is information diseminating, how quickly did the subway system come back, to run an election balloting in the immediate aftermath, etc?

One might consider the underying economics behind the cost vs redundancy trade-off. To be fair to all parties, the recovery may not have felt fast but in the context of what happened, I'd suggest it was impressive. And there is an upfront cost to de-centralizing systems -- how many would prefer to spend another $20 on every United ticket in return for getting systems online 3 days earlier in the case of the next 100 year [10?] storm across its network?

Shawn Irwin said...

The e-commerce sites should be not depend upon the share market since if there is any disruptive in the share then there results in downfall of shares which in return makes the e-commerce sites to provide less discounts,deals and vouchers.
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john said...

Maybe we should have a backup plan. But isn't making such a dramatic change expensive? It feels like irrational risk-aversion. Although there is a pattern of bad events happening recently, we shouldn't decentralize whole systems. That would be asking a lot to prepare for a relatively rare event, especially for HFT's that use proximity to server farms to trade more quickly and efficiently than the competitors.

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