Hurricane Sandy, The Economy And The Stock Market

Includes: HD, ITB, LOW, SPY, SSD, WY
by: Martin Lowy

On Tuesday, Mike Shedlock, who blogs as Mish, pooh-poohed the idea that spending to recover from Hurricane Sandy would benefit the economy. "Broken windows and floods have a net economic cost, not a benefit," he averred. "In general, it is never of economic benefit to have productive assets destroyed." On Wednesday, Pater Tenebrarum chimed in on S.A.:

Allegedly, the massive destruction of wealth hurricane 'Sandy' will leave behind has a 'silver lining'. . . . [But] The loss of wealth the hurricane has inflicted is very real; the wealth destroyed by it is most definitely gone. . . . Certainly companies will try to make up for lost production and the dwellings and infrastructure that have been damaged by the hurricane will be rebuilt. This rebuilding activity is then recorded as an 'addition to GDP'.

Suppose though there had been no hurricane. Then all the resources that must now be expended on rebuilding what it has destroyed would be available for other uses. In that event, it would indeed be possible to create additional wealth. The hurricane has rendered us poorer by precisely what it has destroyed - the rebuilding activity is merely undertaken to catch up to the status quo ante.

Mr. Tenebrarum then takes off in hot pursuit of the broken window theory (discussed Thursday on S.A. by Tim Ayles) and other Keynesian heresies.

It may be true that over the very long term the loss of wealth will be greater than any positives that rebuilding creates. But I think that Shedlock and Tenebrarum, in their haste to debunk Keynesianism, omit consideration of some important factors. These include

(1) Some of the destroyed or damaged buildings and infrastructure were weak links. The storm exposed them as such, and rebuilding them will be a net positive. This is a form of "creative destruction" that, I assume, Messrs. Shedlock and Tenebrarum would applaud if accomplished by competition rather than by a natural disaster. I believe that strengthening of hitherto weak links in the infrastructure of the great cities of the northeast and mid-Atlantic will be a plus for the economy for many years to come. In times like the last five years, states and municipalities, being under pressure economically, put off needed repairs and improvements. A catastrophic event like Hurricane Sandy makes many deferred repairs and improvements no longer optional.

(2) On a net basis, repairs most certainly will consume more person-hours than were lost due to the storm. Current employment at the cost of a loss of buildings and infrastructure accumulated over a long period of time has a short-run benefit that could last for a year or more.

(3) Some of the damage will have been insured. (Estimates I have read are in the $7-15 billion range, but it would not surprise me if the number ended up higher.) By paying claims, the insurance companies take relatively inactive money that they have built up over a long period of time and turn it into high-powered money that creates GDP and jobs without subtracting from either in the short term. The reserves will have to be replenished out of earnings over a period of years, and thus the insurance company's stockholders may, in theory, suffer. But probably even they will not suffer greatly, since it is in the nature of casualty insurance to pay out large claims from time to time; doing so is built into the capital structure and investor expectations.

A Net Positive for the Economy

I believe that the impact of Hurricane Sandy on the U.S. economy will be a net positive over the next 12 months. At first the lost business will be very substantial. Except to the extent they are insured, those losses will be borne mostly by businesses, which will be less profitable in the weeks during and after the disaster, and by governmental entities. Most individuals will not lose pay as a consequence of their employers closing for a few days or a week. But the money to repair the damage will be good for businesses and good for employment.

On a net, long-term basis, it may be that the storm's damage will outweigh the apparent benefits from rebuilding. But in my opinion, in the short and medium term, the benefits will be real because the money for repairs will come largely from the Federal Government and insurance companies. The money coming from the Federal Government of course increases the deficit - which is a long-term problem - but on an immediate GDP basis, the government spending will be a plus, and it will cause people to be employed. The money coming from insurance companies will have an even more beneficial impact because it will take relatively inert money and transform it into high-powered money that buys goods and employs people.

Look at a casualty insurer or reinsurer's balance sheet. If the company is well run, as most of the big ones are, it will have a large amount of liquid securities that can be sold to provide the cash to pay out claims. The sale of those liquid securities is likely to have little impact on the highly liquid global marketplace for such securities. The impact on the selling insurance company depends on the level of its reserve for catastrophic losses. Such reserves are an accounting entry that has nothing to do with cash or securities on hand. If the reserves are adequate, then from an accounting point of view, the cash paid out in claims is offset by a reduction in the reserves, and the net capital of the insurance company is not adversely impacted. Even the earnings of the insurance company are not significantly affected in the short term if the reserves are sufficient. The reserves will have to be rebuilt over time out of earnings, but the immediate hit is modest. In cases where the reserves are inadequate, then there will be an immediate hit to earnings. But in a low-interest-rate environment like the present, the reduction in earning assets will have little impact on earnings.

An improving economy should be good for the stock market, except to the extent that valuations already reflect an expectation of an improving economy.

What Stocks Will Benefit?

What kinds of stocks should benefit? Basically, any company that has a business concentrated on construction or construction components that is strong in the northeast should benefit. Homebuilders [think about iShares DJ US Home Construction (BATS:ITB), for example], Home Depot (NYSE:HD), Lowe's (NYSE:LOW), Simpson Manufacturing (NYSE:SSD), and Weyerhaeuser (NYSE:WY) are a few names to think about. The problem with most of them, however, is that many investors have jumped on the bandwagon ahead of you, so valuations are high.

Basically, I think the storm is bullish for stocks over the next six months, all other things being equal. If I am correct that the economy as a whole will benefit, then the market as a whole should get a boost that would make broad-based ETFs such as S&P 500 (NYSEARCA:SPY) a better holding at this time than I would have predicted a few days ago. Candidly, however, aside from a few small purchases, I am having trouble identifying companies that have not already appreciated significantly and, therefore, carry rich valuations.

Disclosure: I am long ITB, SSD, LOW. 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.