Externalities Abound (Risk Complexity, too)
This morning, I want to address the issue of externalities, and managing risk in an era of ever-increasing complexities.
Equity investors deal with a variety of risks: Earnings, Business Cycles, Execution, and Valuation. These are the traditional risks that are, for want of a better word, ordinary. Whether you want to call them typical or usual or normal, they are the standard factors that make stock selection a fun challenge, and separate good companies (and their equities) from lesser investments.
Beyond those challenges, markets must also confront “Externalities.” These are the risks that come from outside of the normal business cycle: War, Credit Crisis, Oil Shocks, Terrorism, Weather, Earthquakes.
Note that investors have always had to deal with these — they have pre-dated markets, currently co-exist with them, and will eventually outlive them. Externalities are a part of life, and you can neither plan for them nor ignore them.
Consider the Cold War: During the 1950s, ’60s, ’70s and ’80s, the threat of nuclear conflagration between the USSR and the USA was the geopolitical backdrop. Yet 3 of 4 of those decades saw very good market returns. Threats of extraordinary, extra business cycle events did not derail equity returns, though a good argument can be made that post detente, global markets screamed higher (contra: that was a 30 year period of falling rates).
It is important for investors to understand these externalities. Every day, headlines such as this — ‘Funding Crisis’ averted for Italy, Spain cross the tape. They are a part of the global backdrop. They cannot be ignored, but they should not be obsessed over.
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There is one element of these externalities that should be analyzed, focused upon, even obsessed over: The current challenging complexities are entirely man-made. No, the European banking crisis is not a Tsunami, not an earthquake, not a drought. Along the same lines of analysis, the US credit crisis, housing collapse, and Great Recession were not a meteor falling from the sky, but instead were entirely foreseeable and preventable. They were brought on by a radical recklessness that was ignored for years, until pretending it didn’t exist simply became impossible.
In the US, the Smash & Grab was the world’s greatest reallocation of wealth — first from shareholders to corporate insiders, than then from taxpayers to insolvent Banks. Note that this wealth transfer was not from the poor to the rich, but rather, from the middle and upper middle classes to the Über-rich. The political implications are very, very different.
Risk complexity abounds . . . Investors better get used to it.
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January 5th, 2012 at 7:56 am
BR, this is a nice Thought Piece..
literally, something, more, People should ‘mull over’, at the min.
for, surely, this..”…Risk complexity abounds . . . Investors better get used to it…”, especially for those that haven’t contemplated the Idea(Fact), couldn’t be a more Important alert..
~~
though, with this..”…“Externalities.” These are the risks that come from outside of the normal business cycle: War, Credit Crisis, Oil Shocks, Terrorism, Weather, Earthquakes…”
why is it, that so few are willing to acknowledge that ‘Political Risk’ is a Valid, for the U.S., Factor?
for an Ex.
http://www.mcall.com/news/local/mc-allentown-pa-firefighters-retire-20120104,0,7856335.story
“…will strain the department’s already underfunded pension account and city contributions to it will jump next year by $1.1 million, or 25 percent, to $5.1 million, according to a recent actuarial report. The retirements will also cause a spike in overtime wages for six months while new recruits complete their training, officials say.
Under the contract that was set to expire Dec. 31 but remains in arbitration, firefighters had overtime earnings calculated into their pensions, which often pushed pensions far above their base salaries. Mayor Ed Pawlowski has vowed the next contract will be more stringent and put pensions in line with earnings.
The contract with the fire union is the last vestige of a crippling deal made by former Mayor Roy C. Afflerbach, Pawlowski said Tuesday.
The result of that deal — skyrocketing pension costs threatening to consume one-quarter of the city budget — is one of the biggest issues facing the city, he said…”
and, also, to note that this..(as an Action)
“…the Smash & Grab was the world’s greatest reallocation of wealth — first from shareholders to corporate insiders, than then from taxpayers to insolvent Banks. Note that this wealth transfer was not from the poor to the rich, but rather, from the middle and upper middle classes to the Über-rich. The political implications are very, very different…”
is far from ‘coming to Rest’/'being Over’..
or, differently, the ‘Crimes’, yet to be Prosecuted, are going to, continue, to Cost..and, more than Financially..
January 5th, 2012 at 8:17 am
Some more “risk complexity” to ponder.
http://globalresearch.ca/index.php?context=va&aid=28503
Advanced war preparations are ongoing. Barely mentioned by the Western media, although confirmed by Israeli press reports, the Pentagon is preparing to send several thousand US troops to Israel.
January 5th, 2012 at 9:23 am
We have witnessed strings being pulled in order to influence both small and large aspects of the global economy — the choosing of winners and losers. War, poverty (and, in some cases, famine), disenfranchisement (just wait until the title-holders of all of the foreclosed properties moldering on the market are chosen), abandonment of the Rule of Law, blatantly and obviously dishonest monetary and accounting systems, unpunished corruption, and the elevation of an etherial legal entity into a full uber-personhood (the corporation springs, fully formed, from the head of Zeus, so to speak).
Unless you are the one (or one of the ones), pulling strings, everything is an externality.
I don’t know if it’s normal or simply a matter of my perspective, but it seems that over the past few years, natural disasters have hardly caused a flicker in the overall economic picture. The transfer of wealth and power is a juggernaut immune to the forces of nature (for now).
January 5th, 2012 at 9:39 am
@Raleighwood:
I love a good conspiracy theory as much as the next guy but…calling these joint missile defense exercises “advanced ware preparations” is silly. In Gulf War I, the Iraqis tried to draw Israel into the conflict firing SCUDs into Israel. The US sent Patriot missile batteries. Those are the facts. Now whether the Patriot missiles were effective or not in shooting down SCUDs (I think the evidence is not), the conventional wisdom in both the US and Israel is that they were effective in helping to keep Israel on the sidelines. It strikes me as eminently sensible to have planned these joint exercises regardless of anything else especially is one wants to minimize any potential conflict. The Iranian government is in trouble, sanctions or no, for the same reason our own current government is in trouble – the economy. Our own economy is terrific in comparison the the sad state of the Iranian economy. Would the Mullahs sanction the Iranian version of “wag the dog”? Why not? We’ve done it so why wouldn’t they? Keeping Israel on the sidelines in such an event is eminently sensible if one wants to keep such an incident somewhat confined…of course that assumes the Obama administration would want to keep it confined. I sure hope so.
January 5th, 2012 at 9:57 am
The war machine’s metabolism is stoked. It’s hungry for profits, and will be fed, even though we can’t afford it.
Saw an old friend at Costco last weekend, a very conservative fellow. He said he hoped that funding for the Marine Corps project he was working on was extended so that he wouldn’t be out of a job. My inner Christopher Hitchens took over, and I told him to stop stealing my money. It’s amazing how those who would want every form of government assistance withdrawn from others are rendered speechless at the idea that they are an integral part of the problem they seek to remedy.
January 5th, 2012 at 10:32 am
“…I told him to stop stealing my money. It’s amazing how those who would want every form of government assistance withdrawn from others are rendered speechless at the idea that they are an integral part of the problem they seek to remedy…”
Petey,
right? it is bewildering…so many, so reactive, such little contemplation..
truly, ’tis no way ‘to run a “Wh*r*h*us*” ‘..
~~
think that dude realizes how much He has in common with the OWS ‘individuals’ ?
(both, more addicted to OPM than, either, would care to admit..)
January 5th, 2012 at 11:08 am
@Petey and Mark
Remember the August of discontent over healthcare reform and “keep your gov’t hands off my Medicare”?
Read or re-read Taibbi’s Tea Party piece, which is actually more sympathetic than one might think. What animated them was the idea that healthcare reform would give government money to “other” people who are of course undeserving leeches and since it must be a zero-sum game that must mean less money for the truly deserving, i.e., them.
January 5th, 2012 at 11:08 am
Dear Mr. Ritholtz,
Please go on. You have more ability and more willingness than others to say what needs to be said. On the smash part, you have begun to put into words that the MERS system was wrong. We all have enormous value tied up in the real property system because it was a system of paper for all to check and rely upon. The smash part has cost us $7 trillion of value, but have we really understood that title to millions of properties will have clouds for who knows how long? We are all going to be buying in a market where hidden title bombs will lurk, leaving anyone of us to the whim of some judge on a county court bench. What asset replaces real estate as a safe place to store value? Gold? Cash? Shares of corporations? If we return to real estate, what will be the cost to restore the system, which consists of thousands of offices with millions of documents in each community, large and small. And even then, if the MERS system is a failure, do we return the the poison of the S&L crisis, a world with systemic risk for banks who lend long and borrow short. It feels like–Well, Ollie, it’s a fine mess you have gotten us in now.
January 5th, 2012 at 2:29 pm
They were brought on by a radical recklessness that was ignored for years, until pretending it didn’t exist simply became impossible.
Have you been paying attention to Heritage? the Republican primaries? Cato?
C’mon Man, a big enough chunk of the system continues to pretend to prevent the necessary corrective action.
January 5th, 2012 at 4:30 pm
A great deal of complexity is also generated by the integration of our economies and by the integration of the sectors and companies within each economy. This increasing level of integration makes it difficult to predict the effects of one action, or one externality on an investment, a sector or even an economy as a whole. What may look like a series of secondary effects may bend the curves in unpredictable ways. Bundling (integrating) mortgages into sellable instruments was seen as a way to reduce risks, but this integration and new level of complexity created new risks.
We need to find ways to simplify, localize, and decouple things so that we may understand with greater confidence how they affect us.