Caution: Event Risk Is Significant

by: William Pike, CFA


ISIS, Russian adventurism, Ebola, and our terrorist- and disease-porous southern border present higher than normal event risk.

Commerce-disrupting events impact company earnings and therefore stock prices.

Cushion your portfolio with cash. My stock allocation is down to 40%.

Event risk refers to the possible occurrence of a political, military, natural, or other event that is: 1) not normally encountered in the investment environment, 2) largely unpredictable as to timing or degree, and 3) will have a significant impact on the market as a whole, or one or more sectors or stocks. Event risk does not refer to revisions in earnings estimates, disruptive product introductions, stock buyback announcements, changes in government economic forecasts, etc. These are part of the day-to-day investment landscape.

An adverse event is one which will have a negative impact on world or regional commerce, and therefore on company earnings, and therefore on stock prices. While specific adverse events are not predictable, an environment where the likelihood of such an event is high, is detectable.

In my forty years in the investment business, event risk has never seemed higher than now. It is particularly high in the mid east in general, and from ISIS in particular. Russian, Chinese, and Iranian adventurism carry the risks of inadvertent hot war, commerce-disrupting tariffs or trade wars, or other unforeseeable events. Ebola spread or containment measures also threaten commerce disruption.

An adverse event from any one of these may have a low probability of occurrence, but together, the probability of an occurrence among them seems high.

Following an adverse event, investors typically shoot first and aim later, i.e. sell stock, and then assess the degree of damage to a company's future earnings, cash flows, etc. In the near-term, stock price valuation means little. Panic selling, shorting, and forced margin selling can take the market lower than reasonable valuation models suggest. Valuation in the short run means little, but not nothing. Your judgment on valuation may tell you when to tiptoe (or plunge) back in. Relative valuation can help you determine which stocks to buy.

How I am playing it

Right now, reflecting my event risk concern, as well as a possible slowing of the world economy, 40% of my investable funds are in stocks. Assuming no adverse event, my plan is to go to 45% invested with a 10% further decline in the market averages, 50% invested with a 15% decline, and 60% with a 20% decline. A market decline does not change the probability of an adverse event, but it does cushion the fall should one occur. I will be more comfortable with a higher stock allocation when stocks are lower.

Do I rigidly adhere to this discipline? No. There are always new variables that makes me rethink and reset my buy triggers and investment allocations. But having that discipline helps me avoid panic, and forces me to remain focused on fundamentals and not lose sight of valuation.

If a major adverse event does occur, stock prices will react quickly and I will then re-assess the impact on the economy and then-current valuations. While such future analysis is beyond even guessing prior to an event, cushioning the downside from such an event by holding a lot of cash, does make sense to me now. My asset allocations will be revised when the air clears, one way or the other.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.