The Difference Between Risk & Uncertainty

Interloper Interloper November 18, 2011

Kid Dynamite highlighted the best quote from HBO's Too Big Too Fail early on and it's a good one to keep in mind during periods of high market volatility:

"You're getting out of a Mercedes to go to the New York Federal Reserve, you're not getting out of a Higgins Boat on Omaha Beach. Keep things in perspective."

We all sweat every tick of the market and infinitely parse its behavior but the fact remains that the market is not only a bad metaphor for life in its entirety but also much less reflective of the US economy than most suppose. About 40% of S&P 500 profits are generated overseas and China, as the marginal buyer of commodities, increasingly determines every day costs like gasoline. What happens in the market and what happens outside your window are much different things, for better or worse, and this implies that tearing our eyes from the screen and looking out the window more often is a good idea when the indexes are slopping around 5% intraday as they have been.

Strategy-wise the problem remains that the widely divergent potential outcomes in Europe, ranging from the relatively benign (ECB/IMF steps in, guarantees sovereign debt and prints oceans of euros) to the almost apocalyptic – disorderly dissolution of the Eurozone, mass bank failures and a general continental descent into Mad Max territory. Valuing equities effectively in such as environment is a near impossibility. Not only are earnings and cash flows subject to non-business policy decisions that could go either way, but the discount rate at which present value could be calculated is, at best, a ballpark guess.

I would suggest that outside of day trading, credit and highly cyclical/global economic-related sectors should be off the table for most investors until either more clarity is evident in Europe or valuation levels fall close to megacheap, March 2009 levels. This may seem somewhat cowardly, but I refer again to Michael Mauboussin who has gone to great pains to explain the differences between risk and uncertainty. He defines risk as a situation where the probabilities are known, like blackjack, where cogent decisions can be made. Uncertainty involves cases where the odds of success or failure can not be rationally approximated with any accuracy, and in these cases sensible investors should not play. Finance and higher beta cyclicals are, I would argue, in the latter category.

Earnings will be extremely difficult to predict over the next few months but there are secular trends that will, or are occurring and these are the areas investors should putting their analytical skills to work. Economic growth rates have little correlation with health care sectors, as an example, although each subsector is subject to its own specific drives, government policies primary among them. Admittedly, demographics has historically been a difficult theme for investors because relative growth in older populations happens at a much slower rate than the market's attention span can handle. However, if investors are looking for opportunities in the event of a major sell-off, these are the areas where they go shopping with the least amount of concern as to future global economic growth rates.

There are other market sectors where secular trends with insulation from potential poor general growth rates are apparent. The massive shift to wireless telecommunications continues(the most recent data I've seen predicted more than 100% annual growth rates for wireless data traffic) and surprisingly, luxury goods and organic-related food companies have shown consistent profits only partially susceptible to changes in global GDP. Consumer staples stocks with specific growth drivers, growing market share in Asia for example, can become extremely attractive during in weak markets. Again, indicating that these sectors have less economic risk does not necessarily imply less risk overall.

Not to sound like your broker or Institutional Salesperson, but periods of investor paralysis are ideal for building a shopping list of companies in lower beta sectors that may get thrown out with the bath water of a temporary meltdown. Establishing a "must-have" price for a few of them (which, btw, won't matter if you're too scared to pull the trigger when it hits them. Remember that execution matters more than design for strategy) could set you up for outsized, relatively less stressful returns for a considerable period.

This is terrific.

You mention demographics in passing. The Census Bureau released a significant report on longevity yesterday (and that I wrote about in two different posts this morning) — the over-90 age group is growing dramatically. In terms of trading and investing, it’s unclear what that means (to the extent market players can think that far out, as you note). On the one hand, the recent report out of the SF Fed says Boomers will be a drag on returns; a 2009 CBO report says otherwise.

For sure, it’s a big deal but the changes aren’t much quarter over quarter, which is the usual time frame for investors lately.

The Difference Between Risk & Uncertainty

Related Articles