two preliminary points

stock market implications

Some exogenous threats/events have few.  For example:

–the Y2K worries that all the world’s computers would cease to function on January 1, 2000 turned out to be unfounded

–SARS was contained, and did not evolve into the worldwide pandemic some had feared

–I doubt French voters’ choice of a new president in upcoming elections will make a crucial difference in the way the Eurozone crisis will play out.

risk preferences

Let’s say that past market-moving exogenous events have depressed stock prices by 20% have taken six months to be fully discounted, just get a sense of possible loss.  I don’t think there is a “typical” exogenous event, however.  The two big oil shocks were a lot worse than that; after 9/1/2001, stock prices fell about 12% over a few days and then began to recover.

Still, the numbers allow me to frame a question.  If you thought a hard-to-analyze, but potentially negative, event might be coming down the road, would you change your allocation of assets to the stock market?  If you’re not okay with a (hopefully) temporary 20% loss in value, you should rethink where you have your money invested.

what makes an exogenous threat/event different?

1.  Exogenous events are typically all or nothing situations.  The event either happens or it doesn’t.  There are no shades of partly or maybe.  This makes it harder to hedge by arranging your stocks to benefit from a middle-of-the-road outcome.

2.  Their timing is very hard to judge.

3.  They typically occur in areas where understanding them requires knowledge outside the skills and experience of professional investors.  So they’re hard for investors to analyze and handicap.

4.  They can involve a relatively rapid (in macroeconomic terms, anyway) series of actions and counter-actions.  The exogenous threat of the moment–possible Israeli bombing of Iranian nuclear facilities–is an instance.  Will Israel bomb Iran?  If so, will Iran retaliate?…

my approach

When dealing with anything that’s important but hard to decide about, I think the ideal position for a portfolio to be in is one where the issue is irrelevant to performance.  In that way, you’re not forced to bet on something you have no insight into.  In the case of an exogenous event/threat, however, that may not be possible, particularly for a growth stock investor.

You can, and should, pay attention to two factors:  pre-event portfolio positioning, and having a reaction plan if/when the event occurs.

Let’s take the crisis du jour, an Israeli attack on Iran, as an example.

This is a highly emotionally charged and complex issue–one that I know little about.  The stock market fear is that Israel will bomb Iranian nuclear facilities, Iran will retaliate.  Oil prices will rise.  The world will be drawn into accelerating armed conflict in the Middle East.  Media reports suggest than any attack must commence before the end of 2012, by which time Iranian plants will supposedly be too heavily protected for an attack by Israel to be successful.

pre-event portfolio positioning

My guess is that an Israeli attack would produce a short, sharp drop in stock prices, similar to that after 9/11, followed by a period of assessment.

I don’t see any way of organizing a stock portfolio so that it wouldn’t be very sensitive to a selloff, other than to adopt a very defensive overall portfolio posture.  The problem with doing that is that it forfeits most upside from the time you put it in place.  Suppose the exogenous event doesn’t take place?  Or, suppose the market goes up by 10% before the event and then declines by 8% as it unfolds.  I thinks case, you’re probably still worse off from being defensive than you would have been by doing nothing.

What am I doing instead of this? …stuff I should be doing anyway, but I’m paying closer attention than usual.

–I’m combing through my portfolio for “iffy” stocks that have achieved most of the outperformance I’ve envisioned for them and which I’m holding onto partly from inertia, partly to maintain market exposure.  I’m starting to pare those positions back.

–I’m being more price conscious with anything I’m buying.

–I’m thinking about energy stocks, and US chemicals the use natural gas feedstocks–but I haven’t bought anything yet.

–I’d think twice about any companies I own that have plant and equipment in Israel (other than INTC, I have none that I’m aware of).

a reaction plan

This is at least as important as pre-event planning.  An awful lot depends on judging what’s going on while an event-related selloff is in progress.  But the general idea would be:

–to buy, rather than sell

–to search among the biggest losers for purchase candidates that have been beaten up without good reason

–to reverse the defensive moves you made in anticipation of the event.  In this case, this would mean selling energy producers and replacing them with energy users.

When to start such contrary moves depends as well.  When Saddam Hussein invaded Kuwait in early August 1990, for instance, oil stocks hit a peak of relative performance about two months after, in late September-early October.  That was long before the US attack on Saddam the following January sparked a general market upturn.

After 9/11, in contrast, the faster one bought the better.