Investors like numbers. They like quantifiable, objective measurements and things that can be reduced to a mathematical equation. For most investing, numbers are great; understanding how many iPads are sold in a quarter, combined with knowing how much it cost to produce, distribute, and market those iPads, can make for a reliable and usually profitable model on whether to buy or sell stock in Apple (AAPL).
Unfortunately, there are other, less quantifiable aspects that will impact whether your portfolio goes up or down. Many market managers will attempt to quantify the unquantifiable through statistical analysis and the probability of estimates of an event that could impact a stock. Sometimes this works and sometimes it doesn’t, but the premise is usually predicated upon the idea that human nature is, at least to some extent, predictable, and thus analysts can predict the future and achieve better-than-average returns on their investment because they took on the risk of being wrong, but were actually right.
Some risks cannot be predicted. No investor predicted 9/11 and its impact on the market. Few investors predicted the housing boom and crash, and many fund managers were impoverished or unemployed by the crash of 2008-2009. Despite this, many investors place enormous stock in beta, the measurement of systemic risk that attempts to predict how a particular asset responds to larger market swings. But no one can know exactly when those swings can happen, or what can trigger them.
When it comes to systemic risk, there are several factors that investors will focus on. One will be the likelihood of a global downturn and how that will impact a particular stock. Another will be the chance of a sudden and unexpected crash, like that of 2008. Another will be the likelihood of war and the effects of a war on investments.
The latter is becoming a fading memory with younger investors, whose idea of war may be the Afghanistan and Iraq conflicts of the 1990s and 2000s. These wars had limited direct impact on the stock market, except for those sectors who were directly involved in the efforts: the aerospace and defense industries, whose ETFs (PPA, ITA) post-date the bulk of the war efforts. (You can see the performance of the sector by looking at constituent companies, like LMT, BA, and NOC–all were on a steady incline from 2002 to the 2008 crash).
In previous eras, the impact of war on the stock market was tremendous. The WWII stock market saw steady growth as Keynesian theory played out in the United States and GDP flourished to fight the Axis powers. This brief look at history demonstrates that war is a type of systemic risk whose impact on the stock market is not a direct and always predictable correlation. Not without some qualitative analysis–an understanding of the wars based on a historical perspective and cultural insight.
A More Modern Example
To demonstrate this point, let’s take a look at South Korea, whose KOSPI 100 index has steadily risen since the IMF bailout of 1997 which hit Korea and other emerging markets. Since then, South Korea has maintained a sharp and steady growth in GDP and economic efficiency spearheaded by the chaebols, a group of family-owned and controlled conglomerates who have become household names in America (Hyundai, Kia, Samsung, LG).
There is one thorn in the side of South Korea’s steady growth into first-world prosperity: North Korea, whose belligerent threats of war pop up every once in a while. Whether it’s a missile launch, a nuclear weapons test, or just the promise to drown Seoul in a “sea of fire”, North Korea’s penchant for threatening South Korea and maintaining a cold war stalemate usually has a cooling effect on their southern neighbor’s economy. This can be measured by coordinating the volatility of the company’s most important stock index, the KOSPI, with the timing of threats from North Korea.
Over time, the impact that North Korea’s threats has made to the KOSPI have had less and less of an effect on the southern country’s stock market. Most recently, North Korean dictator Kim Jong Eun announced his country’s plans to launch a missile; after the announcement, South Korea’s KOSPI actually went up–and most likely due to other news deemed more important than the dictator’s threats.
A look at the KOSPI’s performance
One could say that the South Korean economy has largely decoupled from the belligerence of its northern neighbor. There are just far too many other issues that are considered much more important by the marketplace, such as the economic climate of the United States, Japan, and China, South Korea’s largest trading partners.
If we look at the KOSPI’s performance in the past 5 years, we can see very clearly how the South Korean market is actually tied to a very different world than Kim Jong-Il and his family’s regime:
To understand this charge, let’s choose a couple of dips, since those are the anomalous events in a bullish tendency for the index. The most obvious dip is at the end of 2008-2009, when the subprime mortgage crisis originating in the United States caused a similar curve in the indices of just about every developed nation in the world; the fact that South Korea’s equities market followed suit demonstrates South Korea’s dependence on American prosperity.
Another interesting and sharp dip was also due to the United States: at the end of summer in 2011, markets panicked as the U.S. Congress flirted with the idea of defaulting on its sovereign debt. Such an unprecedented historical moment impacted stock markets everywhere, including South Korea. Again, the South Korea-U.S. link has demonstrated itself.
Now let’s look at a more Korean historical moment: the death of Kim Jong-Il. This event occurred on December 17th and was a tremendous event of political uncertainty and concern both in South Korea and the region. However, if you look at the tail-end of 2011 on this chart, you see a relatively stable period (arguably one of the most stable periods in the past 5 years), followed by a strong rise in early 2012 followed by a fall at the beginning of May.
Unsurprisingly, that’s pretty much what happened to the S&P 500 as well.
An even more interesting moment of North Korea/South Korea decoupling can be seen at the end of March 2010, when a North Korean torpedo hit a South Korean naval ship and killed 46 of its crew. That moment is absolutely unidentifiable on this chart.
This is an important lesson because it teaches us something: systemic risk is ever changing and is the result of an emotional response amongst market participants. There is no objective reason to assume that North Korea is any less volatile or dangerous to South Korea, and plenty of reason to assume that it is actually more volatile; as the North Koreans learn of the outside world and sustain decades of starvation and humiliation, it’s only a matter of time for the system to break down. But the market doesn’t seem to think so–or doesn’t care.
We cannot predict the future, and we cannot know exactly how the collapse of North Korea, or an uptick in aggressions, would impact the profitability of the companies in the KOSPI 500. But the market isn’t even pricing that information into the stock anymore, yet a real attack on South Korea would undeniably have real economic consequences.
Defining your own “beta”
It is up to the individual investor, then, to address the question of systemic risk and what indicators are actually at play and being ignored by the market. Contrarian investors often take this approach; by calling out the market’s overall failure to identify a real risk to the system as a whole, they will short parts or all of the market with high-risk, high-reward investments. Nassim Taleb is perhaps the most famous investor of this sort.
Other investors will instead try to find hidden risks and rewards that are undefined in the marketplace and try to invest aggressively in the more profitable sectors of a market. By understanding how a hidden risk can hurt an entire marketplace, investors can bet on another asset and profit big time. For example, investors who bought bonds in late 2008 were laughing while stock pickers were crying.