Up To Our Necks In It: The Misunderstanding Of Risk And Its Consequences

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Includes: AQMNX, BIV, BOND, IAU, OTCRX, QLENX, TLT, TOTL, WHOSX
by: Kevin Wilson

Summary

Hurricane Harvey is yet another natural disaster that illustrates the way risk works, i.e., primarily through non-linear cascading of losses once certain thresholds are exceeded.

Because of the human condition (i.e., a tendency towards denial, complacency, and a gross misunderstanding of risk), each new natural catastrophe is met with expressions of surprise.

The same thing happens in markets during every major crash, as bullish and complacent punters accept completely asymmetric risk while chasing returns at the top.

Human behavior naturally favors these bad results, but they are not inevitable; through an act of will, people can properly evaluate risk and limit or mitigate their losses.

We are now in an extreme market situation that requires a pullback on risk; it makes sense to hold IAU, OTCRX, QLENX, AQMNX, WHOSX, TLT, BIV, BOND, and TOTL.

Hurricane Harvey Flooding, Houston, 2017

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The nation is watching with a mixture of sadness and horror as yet another flood disaster strikes a vulnerable region; this time it’s a catastrophic 1,000-year flood resulting from Hurricane Harvey that has spread destruction throughout southeast Texas. I have written before about how natural disasters illustrate the way risk works, primarily through non-linear cascading of losses once certain thresholds are exceeded. There are numerous examples (e.g., Hurricane Sandy, 2012 [see photo]; Hurricane Katrina, 2005 [see photo]) of very damaging or even catastrophic floods hitting areas where such an outcome is highly probable, yet it seems each time that few are prepared for what happens. The floods hitting Houston and the rest of the Texas coastal plain are hardly a surprise to anyone with an understanding of major natural phenomena. Yet because of the human condition (i.e., a tendency towards denial, complacency, and a gross misunderstanding of risk), each new catastrophe is met with expressions of surprise and in many cases, a massive loss of life, combined of course with vast property damage.

Hurricane Sandy Flooding, East Coast, 2012

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Hurricane Katrina Flooding, New Orleans, 2005

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However, it is not hurricanes and other natural disasters I’m concerned with here, since these are essentially acts of God and are a part of life. Rather, I am concerned with the relatively consistent lack of planning and preparedness in most urban areas, no matter how obvious the threat or how great the potential catastrophe. This doesn’t just apply to the authorities in charge of public safety; it also applies to many individuals and families who make decisions that have life or death consequences with an amazing level of ignorance and complacency. Although every natural disaster sees great acts of courage and smart decisions by individuals who saved themselves or others, it is also common to see blindingly obvious mistakes that people make (in spite of warnings) that cost them their lives.

This tendency towards poor decision-making in a natural disaster can serve as an analogy for the way people tend to view risk in the markets at the end of a great bull run. The general misunderstanding of risk by many people in crisis situations often does tremendous damage to those same people and their families, whether it is a natural disaster they face, or a market crash. Is there some way that we can improve on the natural tendency of humans to get themselves killed (actually) in natural disasters, or (financially) killed during big market fluctuations? Both types of losses appear to be susceptible to mitigation via successful risk analysis, and therefore are at least partially preventable. But to save oneself (or others), the evidence must actually be evaluated on its merits, not swept under the rug to avoid discomfort.

It was a real shock 12 years ago when almost 2,000 people died in New Orleans in the aftermath of Hurricane Katrina; this happened in spite of the evacuation of at least 80% of the population before the hurricane hit. Many had believed that these kind of losses were a thing of the past. The previously most deadly US natural flood disaster had been way back in 1928, when the Okeechobee Hurricane of 1928 killed more than 2,500 people. The greatest US flood disaster of them all was the Galveston Hurricane of 1900, which reportedly killed about 8,000 people (Wikipedia, 2017). But because of many measures taken to control flooding in numerous jurisdictions, and because it had been many years since a major city had been wiped out by a flood, a sense of complacency had set in, causing the authorities (and others) to drastically misjudge the risk. This is actually quite typical in my opinion, and it is generally reflected in the dubious compromises made in the budgeting and implementation of major civil engineering projects by cities, states, and the federal government.

As a geologist, I have long had a different view, because as part of my professional development I had been trained to look realistically at large scale natural phenomena in space and time. I remember sitting in a class decades before Katrina and watching a technical film about the huge flooding threat to New Orleans, and its likely eventual doom. An article in late 2001 in Scientific American predicted the disaster in New Orleans (republished in Frischetti, 2008). Hurricane specialist Ivor van Heerden had warned for years that New Orleans would not avoid major loss of life if a major hurricane hit (Nova, 2005). In the debriefing and investigation phase after Hurricane Katrina, it was established that the levee system in New Orleans had failed in at least 23 places (Wikipedia, 2017). Some, like van Heerden, had predicted this but were ignored. This failure of the levee system was the largest engineering failure in the history of the US, and it occurred in spite of the fact that the US Army Corps of Engineers had supposedly been preparing for such an event ever since the Flood Control Act of 1965 authorized them to do so. In 2005, however, the major engineering projects around New Orleans, which were part of a projected 13-year program that started in 1965, were still about ten years from their expected completion date (Wikipedia, 2017). People in New Orleans staked their lives on the levee system, but it turns out there was ample reason to question making such a bet. Likewise, the coastal wetlands that historically protected New Orleans were allowed to be systematically destroyed over decades, and the USGS estimated in 2005 that another 700 square miles of wetlands will be destroyed by 2050 (The Economist, 2005).

In Houston this week, the rain continues at record levels, as does the flooding. Buffalo Bayou, the river that passes through the city center, is likely to crest 14 feet above its previous record (Henry Grabar, 2017). Already the 911 emergency service lines have been overwhelmed at times, with occasional backlogs of as much as two-and-a-half hours. A veritable citizen navy of private small craft is aiding in the massive public rescue effort that has so far saved thousands who’ve been stranded or who were in danger from the flood. At this writing, it appears that the authorities have been overwhelmed by the scale of the disaster. This is not unexpected, as no government agency could possibly handle all aspects of a major natural disaster of such enormous scope. It is still too early to know how many more will need help, or how many are already beyond help. Local officials did not encourage evacuation for the reason that there are too many to move (6.5 million in the MSA) in a short time, and because when they tried an evacuation during Hurricane Rita in 2005, it caused as many casualties as the hurricane itself.

City fathers have long favored widespread development that has paved over wetlands and prairies around Houston (reducing some of them by 75%) that used to absorb a great deal of water during periodic flooding. More than 7,000 housing units were also permitted to be built below 100-year flood level since 2010. Banks and insurers have acquiesced in all this development, essentially ignoring the risks they’re paid to monitor.

It is not surprising to a geologist, or a hurricane specialist, or one of the better civil engineers, that this has happened. There have been 40-inch rainfalls before this, all of them associated with other hurricanes or tropical storms that have hit Houston, like previous record-holder Tropical Storm Amelia in 1978. What’s mildly surprising is that people have ignored the risk, even though it is a life or death issue. But really, almost every kind of natural disaster is ignored or improperly accounted for by city planners, civil engineers, and citizens, and huge resources are wasted (and lives lost) as a result. This appears to be the standard human response to risk, for a variety of reasons.

This phenomenon has been studied by a number of researchers. For example, Michael Shermer (2017) has suggested that people seek “cognitive simplicity,” which tends to mean that they accept beliefs quickly but struggle to maintain skepticism, and have a low tolerance for ambiguity. Author Margaret Heffernan (as quoted by Maria Popova, 2014) has suggested that the occurrence of “willful blindness” (choosing not to see) is driven by factors such as the fear of change, the fear of conflict, the impulse to get along or obey, the impulse to accumulate money, or the search for certainty and/or familiarity. There is also something called “confirmation bias,” which involves the natural tendency to search for, interpret, or recall information that confirms one’s pre-existing beliefs (Wikipedia, 2017). This tends to strengthen existing beliefs even in the face of overwhelmingly contrary evidence. Thus, once someone accepts that the levees in New Orleans are safe, contrary evidence tends to be ignored or discounted. And once someone buys into the notion of a great bull market with no end in sight, contrary evidence will tend to be explained away or ignored.

Just talk to any physician about how many of their patients actually take important, life-saving advice. An amazing number of patients would rather die than change their lifestyle, and they often do. Or just sit in a diabetes clinic sometime, like I do, and watch the 30-year-olds come in who’ve already progressed to the level of amputation by ignoring all advice. Or talk to a kidney specialist, who sometimes tells patients that they must act quickly to save themselves or they will die within weeks, only to be fired for telling the unvarnished truth in a critical situation. And consider the number of people now willing to self-subscribe treatments and medications in the absence of any knowledge or training. The internet is all some people need, apparently, even though it is now dominated in some subject areas by pseudo-science and mysticism. Indeed, it seems to me that people in general have absolutely no idea what risk is, or how to deal with it. This is true in spades in the markets, especially when a long bull rally is nearing its end.

Famous investor Howard Marks (manager of Oaktree (NYSE:OAK) hedge fund) recently wrote a compelling discussion of this problem (H. Marks, 2017). Marks describes today’s investing environment as consisting of four major components: 1) uncertainties which are unusual in number, scale, and degree of insolubility; 2) prospective returns for the majority of asset classes are about the lowest they’ve ever been; 3) almost all asset prices are high; and 4) high risk-taking behavior is becoming the norm. The S&P 500 was selling for 25 times TTM earnings at the end of July, compared to a median value of about 15. The measure preferred by Warren Buffett (market cap/GDP) hit an all-time high in June of 145, which seems a bit high when compared to the 1970-95 norm of 60, or the 1995-2017 median value of about 100. Sentiment measures like the VIX have recently reached all-time extreme lows (of fear) for the 27 years it has been measured. Marks has long maintained that, “You want to take risk when others are fleeing from it, not when they’re competing with you to do so.” Marks also commented on the similarity of the recent must-own or “buy and forget” stocks - i.e., the FAANG stocks: Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX), and Alphabet/Google (NASDAQ:GOOG) (NASDAQ:GOOGL) - to the equally popular but ultimately dangerous “Nifty Fifty” stocks of the 1960s, something I’ve also mentioned before.

Another issue mentioned by Howard Marks is the current dominance of passive ETFs in the markets. He rightly points out that these are often just marketing schemes, as evidenced by the fact that mega-cap tech stock AAPL is now held in ETFs that ostensibly track growth, value, momentum, large-cap blend, high quality, low volatility, dividend, and leverage strategies. Clearly what counts is AAPL’s size, not its intrinsic fundamentals; its huge size allows such funds to scale up to larger AUM themselves. The flaw in all this is that passive funds naturally hold the most appreciated (over-priced) assets in general, and they will struggle to find buyers if they have to "sell in a crunch." Losses could be very severe as a result.

Marks also has pointed out that the eagerness of credit markets to fund low-quality loans (e.g., student loans, subprime auto loans) have always been a sign of “elevated, over-financed, risk-oblivious credit markets.” He cites the example of a NFLX issue of $1.56 billion in B-rated eurobonds for just 3.625% in yield, even though earnings were only $800 million annualized, while the most recent cash burn rate was $1.8 billion annually of free cash flow. Likewise, in the emerging markets debt markets, Argentina was able to sell $2.75 billion of a 100-year bond paying 8%, in spite of the fact that Argentina has defaulted eight times in 200 years (most recently in 2014). Amazingly, there were $9.75 billion of bids for this piece of junk.

Famed super-cautious fund manager John Hussman recently pointed out that household financial assets as a ratio to disposable income are at their all-time highs since 1952 (Chart 1). The key observation he makes is to note the huge drops in the charted ratio in 2000-2003 and again in 2007-2009. In other words, on paper people have seemed wealthy, but that would only have remained the case if they then sold at the top in 2000, and again in 2007. But since someone has to end up holding the assets, not everyone can get out. The biggest losers are the ones who took assets off the hands of savvy investors so they (the losers) could chase returns at the top. It is and always has been a fool’s game to chase returns under egregious risk conditions, but very few people will see the risk in time after such a long and huge bull market. Denial and complacency, combined with misunderstood risk, has kept millions of investors from getting out of frothy markets before taking major losses. Confirmation bias and “willful blindness” are often big factors as well.

Chart 1: Ratio of Household Financial Assets to DPI

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I can’t tell you how many people have said to me that there was no way to see 2008 coming, so naturally they lost a ton of money. This, when the signals for a recession and bear market were as obvious as they ever get, a full year in advance. It is understandable that people draw comfort from being part of a group of millions who lost out. It always feels better to be in a crowd, even if it’s a crowd of lemmings. To me, however, it would be much more comforting to have prudently cut risk at the top, as some people (myself included) actually did, thus keeping much more of my (and my clients') hard-earned assets.

Investors hoping to keep their gains from the current great bull market must therefore be willing to evaluate the risk realistically now, and cut their risk some time before the ultimate top is reached. Of course, we don’t know when that will be. Perhaps it’s already happened. Only in retrospect will we know for sure. The alternative to selling early is that many will not be able to “get out” cleanly (meaning re-allocate to their lowest-risk asset configuration) or with sufficiently smooth exit strategies that allow them to minimize losses.

The risk in the markets right now is about as high as it has ever been in market history. Illustrations of that risk are seen all around us, but a few good examples might include: 1) valuations, as shown by extreme median price/sales ratios for the S&P 500 (Chart 2); 2) risk tolerance, as shown by total NYSE margin debt (Chart 3) and extreme low (Chart 4) VIX measures; 3) extreme uncertainty, as seen for example in a measure (Chart 5) of policy uncertainty; and 4) extremely low prospective returns, as shown by (Chart 6) econometric models. Throw in the remarks of industry giants like Howard Marks, as noted above, and there is real cause for concern.

For those readers who’ve made it this far, there is still hope that standard human behavior can be overcome by an act of will, i.e., the willingness to realistically evaluate risk. For those who are always looking for one more quick gain, regardless of the environment, and who see little to be concerned about, we send our thanks for taking our shares off our hands and eventually taking the hit for us, as we reduce our risk, hopefully before the big decline that’s surely coming.

Chart 2: Median Price/Sales Ratio of S&P 500

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Chart 3: NYSE Margin Debt-Derived Credit Balance

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Chart 4: Record Lows in VIX Sentiment Indicator

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Chart 5: Global Policy Uncertainty at Record Highs

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Chart 6: Estimate of Prospective 12-Yr. S&P 500 Returns

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In the meantime, as I’ve said before, the market continues to act like a gambling addict, constantly raising the ante in each new hand, and also raising their collective bets while pursuing ever-increasing risk. Presumably this is meant to provide the way for some to cancel their collective debts and continue to live the good life. This doubling up on risk will continue until it stops. When it stops, the losses will rival those of other famous crashes in 1987, 2000, and 2008. Investing some money in a gold fund like the iShares Gold Trust ETF (IAU) may be in order for all investors. Also, for those discounting a possible bear market, some liquid alternatives like the Otter Creek Long/Short Opportunity Fund (OTCRX), the AQR Long/Short Equity Fund (QLENX), and the AQR Managed Futures Strategy Fund (AQMNX) could be held to protect assets in the event of a market dip associated with deteriorating economic data. Those in a more defensive frame of mind because of the expected market dip should hold some intermediate to long Treasuries, in spite of bearish arguments to the contrary, as a stock market crash would be hugely supportive of bond prices: the Wasatch-Hoisington US Treasury Fund (WHOSX), the iShares 20+ Yr. Treasury Bond ETF (TLT), the Vanguard Intermediate Term Bond Fund (BIV), the PIMCO Total Return ETF (BOND), and the SPDR DoubleLine Total Return Tactical ETF (TOTL) are likely candidates in that event.

Disclosure: I am/we are long IAU, OTCRX, QLENX, AQMNX, WHOSX, TLT, BIV, BOND, TOTL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.