exogenous events: how to deal with them

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.

“exogenous” events for securities markets: what they are

definition

Exogenous means “coming from outside.”  In economic modelling, it means an influence that arises from outside the scope of model and that is, therefore, neither predicted nor explained by the model.

In financial markets, an exogenous event has come to mean:

–some really bad thing that occurs, which has a significant, enduring negative effect on prices, and

–one that’s outside the realm of everyday competition among firms, the cyclical rhythms of a nation’s business cycle or the interaction among countries.

examples

The two “oil shocks” of the 1970s–both of which helped precipitate severe recessions in oil-importing countries–are the events most often cited as exogenous shocks.  Saddam Hussein’s invasion of Kuwait in 1990 is another, as is 9/11/2001.  So, too, is the near-collapse of the US financial system under the weight of dubious sub-prime mortgages.

A definitional point:  unless we’re talking about an invasion from space or a large meteor hitting the earth, no event can be exogenous for everybody.  When OPEC raised the price of oil from $1.70 a barrel to $30+, it was a bonanza for its members.  For the US and Europe, however, whose industry was deeply dependent on a steady flow of cheap petroleum products, the development was a disaster.

The sub-prime mortgage crisis was an exogenous event for the rest of the world, but an endogenous one for the US.

No one talks about the subsequent plunge of crude oil to below $10 a barrel as an exogenous event, either.  The term seems to be reserved for economic calamities that affect the large stock markets of the world.

exogenous events are predictable…

Anyone reading the founding documents of OPEC realizes that it’s a political organization, not an economic one.  It wanted justice, not monopoly profits.  And, although the full details weren’t apparent except after the fact, the production contracts between the oil majors and OPEC nations, which had sometimes been running for several decades, were extremely one-sided in the former’s favor.

…but they often come as a shock anyway…

Many times, professional investors’ focus is narrowly fixed on the domestic business cycle or the competitive interplay among firms in a given industry.  They don’t have any skill or interest in any other areas.  Experience also shows that “big picture” developments are often irrelevant for stocks.  The quality of the information generated by brokers–the biggest information channel professional investors use–about political/social topics is often very low.

…if nothing else, their timing is hard to gauge

OPEC was founded in 1960 but didn’t begin to make a significant impact on oil prices until 1970.  The roots of the sub-prime mortgage crisis can be traced back to Fed actions in 2002-2003, to G. W. Bush’s housing policy, or even to the Clinton administration.  Rampant housing speculation and sub-prime abuses were readily apparent in 2005-06.

In these cases, however, stock market consequences came much later.

being right can be a cold comfort for professionals

Any portfolio manager who adopted a very defensive posture in 2005 in anticipation of the Lehman collapse would doubtless have lost most of his clients before the event itself occurred in 2008.

In addition, one always has to calculate how the performance gained by being correct in predicting an exogenous event stacks up against the performance lost while waiting for the event to occur.  In my observation of “big picture” portfolio managers, their personal ego satisfaction is often the greatest gain they achieve.

In fact, I once had a PM who worked for me tell me that a stock bought eight years earlier, which had almost immediately dropped like a stone and was subsequently sold, hadn’t been a mistake after all.  How so?  The firm was in the process of being bought, by Warren Buffett, and at a higher price than the initial purchase.  Yes, that’s (more than) a little crazy.  But it shows how insidious cognitive dissonance can be.

That’s not to say we shouldn’t worry about exogenous events.  Quite the contrary, because they do occur.  And not all of them are complete bolts out of the blue.  But factoring them into portfolio strategy is a bit more complicated than it might seem.

the current worry

It’s Iran’s nuclear program.  More about this on Monday.