Climate scientists have been warning that extreme weather would become more frequent and intense, yet the 2017 hurricane season and this winter still seem like a brutal wake-up call to nature’s extraordinary power. The frightening possibilities turned into realities across large areas of our country where monumental hurricanes struck the Houston area, Puerto Rico, the Florida Keys, the east and west coasts of Florida, and other coastal and inland areas extending as far north as Charleston. California was drenched in the wettest winter on record, ending years of drought, yet also had the most destructive and largest wildfire season ever. The latest in a string of weather events is the now infamous Bomb Cyclone which brought severe cold, harsh winds and blizzards to the Northeast and coastal areas as far south as Georgia. What can we learn from these events, and what parallels can we draw to man-made disasters in the capital markets?
Preparation Must Occur Before Disaster Strikes
You cannot prepare for a disaster after it strikes. In the days leading up to these especially intense and destructive disasters, headlines warning of their arrival captured the nation’s attention with 24-hour-a-day news reports. The media spent countless hours discussing disaster preparedness. However, as the media shifts its focus to the next ratings-grabbing saga, what happens in the wake of these impressive demonstrations of nature’s ultimate power?
There is no escaping the wrath of Mother Nature. While every year presents its share of calamities, economic losses stemming from these events are considerable. The National Oceanic and Atmospheric Administration (NOAA) reports the U.S. was hit with 16 weather disasters last year, which caused an estimated $306 billion in damages—an all-time high. Requests for federal disaster aid jumped tenfold in 2017 vs. 2016.
Calculating Cost and Loss
Altogether, the cost to the global economy in terms of lost wages, utility disruptions, destruction of public and private property, and decreased productivity—on top of the tragic loss of hundreds if not thousands of lives—poses significant challenges in any attempt to accurately quantify their impact. Natural disasters set in motion a complex chain of events that disrupt local economies and often have a significant impact on the national economy. Calculating (or shall we more appropriately say estimating) damages from a natural disaster is at best an imprecise science. (For related reading, see: The Financial Effects of a Natural Disaster.)
However, the “cost” of a natural disaster and the “losses” that stem from it are not one and the same; economically speaking, they are two distinct issues. Losses occur principally through destruction of physical assets, whereas costs are incurred when an economy chooses to replace, repair or reinforce the assets that have been destroyed.
Parallels to the Capital Markets
The manner in which recent weather events have spared few in their path has similarities to how the financial crisis of 2008-2009 impacted almost everyone around the globe in a significant way, both directly and indirectly. Meteorologists find it necessary to use probability models to identify a forecast cone when Mother Nature introduces new storms. The financial markets present even the most astute investors a comparable challenge, with market performance even less predictable than the weather.
A little more than 10 years ago, markets around the globe were in the crosshairs of a storm that led to a painful multi-year period of volatility, dramatic market losses, and systemic failures of some of the largest, most recognizable companies. Looking back on the Great Recession, the causes and effects now seem so obvious to many, regardless of their financial acumen.
However, in the same way that we watch real-time storm coverage on The Weather Channel, investors back then watched in real time as the forces of leverage, high-frequency trading, algorithmic trading programs and speculation wreaked havoc on asset values, correlations, and the efficient market hypothesis. In advance of the Great Recession, there were several market observers broadcasting their concerns about subprime mortgages and the real estate market in general.
However, few predicted the temporary suspension of the efficient frontier and how nearly all asset classes worldwide would become highly correlated as panic set in. Just as hurricane forecasters are compelled to revise their predictions almost hourly, we learned that computer models and Ph.Ds. in mathematics were little match for a paucity in liquidity and the human emotions of fear, greed, and basic survival instincts. (For related reading, see: The 2007-2008 Financial Crisis in Review.)
Today, as we witness the response to multiple natural disasters, we are still clinging to the incredibly complex and coordinated chain of events launched by central banks around the globe in response to the Great Recession. With the help of global central bank intervention, financial markets have enjoyed impressive advances since 2009, the likes of which are nearly unprecedented in developed markets. However, it is difficult to quantify the residual impact from the Great Recession on investor confidence and emotions that continues to challenge market prognosticators today.
Plan Now to Ride Out the Next Storm
We know from any objective review of history that market crashes occur rather routinely and, in the modern era, seem to follow the business cycle. Therefore, it is not difficult to predict that markets will experience instability and gut-wrenching volatility again at some point in the future. When this will occur, however, cannot be known, determined, or quantified with any meaningful probability in advance.
The good news is the exposure to risk is predictable, with a great deal of certainty, affording us the ability to prepare for it and mitigate its impact. Using the knowledge of the certainty of a bear market does not eliminate its risk, nor does it enable you to circle on a calendar when it will surface. Realizing that this inevitable risk is always with us can help in preparing to mitigate the damages when it takes center stage and becomes the focus of media coverage and 20/20 hindsight commentary from the “experts” of the investment industry.
Whether it’s bomb cyclones, hurricanes or some other demonstration of Mother Nature’s prowess, the time to plan for these risks is not after, or even during, the next storm. The time to put in motion your plan for surviving the next market event is now. It is by no means too late to address your unique financial goals and objectives with a customized financial plan.
The appropriate plan for you is one that will enable you to “ride out” the next financial storm and not turn the unpredictable costs of market disasters into quantifiable, realized losses.
(For more from this author, see: The Costs and Consequences of Financial Illiteracy.)
cr. https://www.investopedia.com/advisor-network/articles/bomb-cyclone-do-you-have-plan-survive-next-disaster/
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