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No one is paid to front run the apocalypse: James Saft

[August 15, 2017] By James Saft

(Reuters) - That fund managers are rewarded for hugging the benchmarks they track is a big reason behind the otherwise puzzlingly mild reaction of financial markets to rising tensions and threats between nuclear powers the United States and North Korea.

No one, and I mean this in the nicest, most humane way, no one is paid to help clients avoid the kind of massive stock market downdraft we’d see if the two went to war. Besides being, like the rest of us, badly positioned to predict what will happen, fund managers face disproportionately large career and portfolio risks if they try to sell up to prepare for a war, making going along for the ride the safest, easiest option.

Last week, which saw President Donald Trump promise “fire and fury” and North Korea say it plans to fire missiles into the waters around Guam, brought a global markets selloff, but only a mild one. The MSCI World Index of stocks lost as much as 1.5 percent at their worst point in the week, Korean shares fell 4 percent and the S&P 500 by about 2.

Markets recovered on Friday and Monday when further egging on by either side did not ensue.

These were not big moves, considering the unfathomable damage that nuclear war could bring, or even the economic dislocation and human catastrophe that would likely come along with a conventional war, something which may not even be an option if a conflict erupts.

People often imagine, based on a misunderstanding of the (anyway faulty) efficient markets hypothesis, that a market reaction to an event is a more or less unerring guide to its impact and the changing distribution of possible future events. Likelihood of horrible outcome goes up, stock market should go down.

George Mason University economist Alex Tabarrok points out that a nuclear holocaust reduces the value of all the things one might buy with the proceeds of stock sales.

“The bottom line is that selling stock doesn’t really help you to deal with a nuclear war or even to improve your life much before the nuclear war happens. The problem isn’t markets,” Tabarrok writes.

“Since any actions you might take in the broader markets are fruitless or very high cost, knowing that the probability of a nuclear war has increased is mostly useless information. You might as well ignore useless information and proceed to buy and sell stock as if the information didn’t exist.”

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Intercontinental ballistic missile (ICBM) Hwasong-14 is pictured during its second test-fire in this undated picture provided by KCNA in Pyongyang on July 29, 2017. KCNA via Reuters

HUGGING THE BENCHMARK ALL THE WAY DOWN

That’s good advice, in that few of us, if any, can credibly think we are good at predicting what Trump might do, how the U.S. state and institutions would react or how North Korea will proceed. The idea that someone who finds herself running a hedge or pension fund will see betting on a nuclear war as a good and fruitful use of her skill set is laughable.

Nothing is also broadly what happened on the stock market during the Cuban Missile Crisis in 1962, when the U.S. and the Soviet Union came far closer than we are today to what very likely would have been a war of mutually assured destruction. Stocks did very little, falling about 1 percent during the crisis and then rising 3.5 percent after it eased. In comparison, an attack by President Kennedy on U.S. Steel earlier that year for price rises had far more impact.

As we are, as investors, and humans, not good at predicting apocalypses and not well placed to profit from them, so our instinct is likely to be to focus on lower-impact issues.

And, as always in financial markets, in order to understand what is happening, you have to understand how the intermediaries are paid.

There is a market for financial advice which proposes to save you from very bad events, but it is selling, not hedge or mutual funds, but, via AM radio, gold coins and freeze-dried food. The vast majority of active mutual and hedge fund managers are paid, in a real sense, not to front-run low probability high-impact events but to beat a benchmark.

Deviating from the benchmark, by selling when the risk of war rises, involves a very considerable career risk to the manager, who may well be dumped if war never comes and his fund lags. If war does come, well then ...

The implication is that we shouldn’t be reassured by a calm market in the face of rising tensions.

Just as the stock market is not the same thing as the economy, it is definitely not the same thing as humanity, and makes, when events turn extreme, a poor barometer of our future fortunes.

(Editing by James Dalgleish)

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