What we are betting on is that the perceived risk exceeds the actual risk. That’s fundamental to the theory of everything we do.
~Wilbur Ross, describing re-insurance investments after Hurricane Katrina

Hurricane Katrina struck the Gulf Coast of the U.S. in 2005, and it was followed by another powerful hurricane several weeks later—Hurricane Rita. After Katrina the media was saturated with vivid images of submerged residential neighborhoods, people stranded on their rooftops begging for help, and bodies floating in the brown water. Katrina was the most expensive natural disaster in U.S. history with total property damage estimated at $108 billion (2005 USD). At least 1,833 people died in hurricane Katrina and the subsequent floods. Insurers were liable for billions of dollars in damage claims, and they raised their premiums over 50 percent each of the following two years.

There was an increasing perception that category 5 hurricanes would devastate this area of the U.S. more frequently. An influential scientific study published in 2005 indicated an increasing trend in the rate of powerful hurricanes in the Atlantic, and Al Gore’s movie, An Inconvenient Truth, about the catastrophic environmental risks of global warming, was released shortly after the hurricanes struck. The 2005 Atlantic hurricane season appeared to imply that worst-case scenarios were coming to fruition even faster than predicted.

Savvy investors, especially reinsurers, smelled opportunity in the high risk perceptions. Both Warren Buffett’s Berkshire Hathaway and billionaire investor Wilbur Ross poured money into Gulf Coast reinsurance enterprises. In a Wall Street Journal interview, Ross explained such investments by stating, "What we are betting on is that the perceived risk exceeds the actual risk. That’s fundamental to the theory of everything we do." Fear irrationally drives up risk perceptions, and savvy investors locate such opportunities and exploit them.

On this Halloween/Dia De Los Muertos weekend, it's worth considering what we fear as investors. Zombie investments that never live up to their potential (a.k.a. value traps)? Ghosts in the machinery of Wall Street that bankrupt us in milliseconds? There are too many risks to track on Wall Street (and in life). Although we cannot understand or anticipate every risk, we can understand when others are going wrong in their assessments.

This month's newsletter is about risk perception, how high risk perceptions create opportunities for investors, and how to identify catalysts that indicate a reversal. We visit the recent decline in crude oil prices - predicted by sustained high risk perceptions - and we'll look at how risk perceptions predict global stock prices and individual stocks over long periods. To take advantage of excess risk perceptions, investors need the courage to doubt others' fear (captured by Wilbur Ross' quote above) coupled with the clarity and patience to identify the issue that, when resolved, will collapse the energy behind the fear - the catalyst.

The Global Risk Premium

Buy to the sound of cannons, sell to the sound of trumpets.
~ Baron Nathan Rothschild, 1812

To find values around the globe, look where others are fleeing in fear. Some topics are so fear-inducing that they fuel discounts, as noted in this prior newsletter.

More important than outright emotion are specific topics that provoke emotion. The following charts are equity curves. These equity curves were generated by our brilliant Head of Research, CJ Liu.

CJ's code selected the top 20 trade-able countries in the news over the past 12 months. The countries were ranked by various variables (references to NaturalDisasters, GovernmentInstability, Fear, or Joy) associated with them over the prior 12 month period. A hypothetical portfolio was generated in which the top 4 (e.g., most fearful) country stock indexes were bought, and the bottom 100 (least fearful) stock indexes were shorted. The positions were held for 12 months. The portfolio was rolled forward monthly and updated with 1/12 of the portfolio since 1999. A summary slide of our findings about the fear-based drivers of global stock indexes is below

As you can see, NaturalDisasters led to a nearly 10-fold return over 13 years, while GovernmentInstability led to a 15-fold return. These equity curves represent emotional arbitrage - arbitraging the risk premium that is reflected in (and perhaps reinforced by) the news flow about these topics.

Of course, natural disasters can destroy an economy. But amazingly, perhaps due to fiscal stimulus and deficit spending to restore infrastructure, the stock market in countries hurt by natural disasters tend to outperform. On our top lists (subscription), we see that Japan, Philippines, and India have the highest level of reported natural disasters over the past month.

Another one of the greatest fears of global investors is not having their money returned. Pension funds and sovereign wealth fund employees largely read English-language financial news, and they would be hard pressed to justify to their colleagues an investment in a country with an unstable government. There's no better way to lose your assets in a country than for its new government to no longer honor contracts with foreigners.

Consider that the Pakistani government has been quite unstable according to the news media, but its stock market has been one of the world's best performing since 2010, as is represented in the following slide (the image titled Pakistan is the Karachi Index value).

Currently, on these toplists (subscription) we see that Hong Kong, Turkey, and India have the highest reported government instability.

Equities Risk Premium

Avoiding fear is no safer in the long run than outright exposure. The fearful are caught as often as the bold.
~ Helen Keller

Day-to-day, most companies don't generate much fear. You can see a fairly weak example of arbitraging fear across the Russell 1000 below using a monthly updating cross-sectional model. This equity curve was generated by ranking the Russell 1000 U.S. equities (the largest 1000 U.S. stocks) by the amount of fear associated with them over the prior 12 month period. Then a hypothetical portfolio was generated in which the top 100 (most fearful) stocks were bought, and the bottom 100 (least fearful) stocks were shorted and the positions were held for 12 months. The portfolio was rolled forward monthly and updated with 1/12 of the portfolio.

Fear was not as impressive as Anger. It appears that the risk premium is higher and more consistent for anger, perhaps because fear is about the unknown, while anger is about something specific going wrong.

When a management team behaves idiotically, investors are usually quick to express their anger and also quick to sell. They hold a grudge, and until the anger starts to fall convincingly, the stock price will often stay depressed.

In the following example of Groupon, investors were increasingly angry at CEO Andrew Mason following a series of setbacks. The anger at Mason peaked just before December 18, 2012, when Mason was named "Worst CEO of the Year" by Herb Greenberg of CNBC. Mason was dismissed as Groupon's CEO on February 28, 2013, the day after the company missed analysts' earnings expectations. Yet, anger was falling dramatically at that time, and the stock quintupled over the 12-months from its low.

From our Top Lists, we see that Pall Corporation, Dun & Bradstreet, and Consolidated Edison have the highest news-based Anger over the past month. From social media, MSC Industrial Direct, Oracle, and Barrick Gold have the highest anger expressed at them.

Crude Emotions

Crude Oil is among the most fear-driven commodities. Because the consumers of crude are price-sensitive, and oil production contains little slack, disruptions significantly impact the price of oil.

One of the most consistent predictors of crude oil prices we've identified is fear. Here is a prior newsletter written during a fear-based spike in the price of oil. When fear associated with Crude Oil is high (above 90th percentile) on a monthly basis, the following month the crude oil price falls an average of 5%, and it has fallen in 100% of the months after this high-fear criteria has been met over the past 15 years. Remember that the risk premium in crude oil leads to a higher price (as consumers hedge), while in equities it leads to a lower price. When fear leaves crude oil prices, then the price falls.

We can use moving averages of Fear to time the price reversals in Crude Oil. The following chart shows how Fear moving averages. When Fear is above average, as it has been recently, the crude oil price tends to fall.

Risk premium isn't all fantasy. The Strait of Hormuz may be mined, government instability can explode into fratricidal civil war, natural disasters occasionally destroy economies, and management incompetence can bankrupt a company. The key to risk management around risk premium is timing. As we saw in the case of Groupon and Crude Oil, in order to trade based on risk perception we need to identify the catalyst that will collapse the risk perception, cooling the hysteria.

Catalysts

We can easily forgive a child who is afraid of the dark; the real tragedy of life is when men are afraid of the light.
~ Plato

Sometimes negative news is only the first trickle of a flood. How can we differentiate when to buy on the dip from when to avoid it? You can see in this prior newsletter how negative news was only the beginning of political troubles in Turkey, and the Turkish Lira and stock index fell significantly over the following months. But the bottom was near. The Istanbul Index is up 21% so far this year.

A value trap is a stock that has been trading at low multiples of earnings, cash flow or book value for an extended time period. Value traps attract investors who are looking for a bargain. But they often don't move up because there is no catalyst.

The disappearance of whatever was raising the risk premium is called a catalyst, and it results in a probability collapse - the feared event is no longer in the range of possibility. For example, when Andrew Mason - the focus of investor's anger - left Groupon, he took with him the anger-fueled risk premium.

As suggested in last month's newsletter, due to fear of government instability, Hong Kong's Hang Seng index would likely bounce over the following month, and it did by more than 5% since the beginning of October. The catalyst there was the movement towards peaceful negotiation by both sides despite ongoing tension, implying that violence would be avoided.

The key to identifying catalysts and timing their reversal is to pay attention. Deliberately identify and document a plan of action related to events that would turn around a negative story.

Closing

It is courage, courage, courage that raises the blood of life to crimson splendor.
~ George Bernard Shaw

Please contact us if you'd like to see into the mind of the market using our Thomson Reuters MarketPsych Indices to monitor market psychology and macroeconomic trends for 30 currencies, 50 commodities, 130 countries, 50 equity sectors and indexes, and 8,000 global equities extracted in real-time from millions of social and news media articles daily.

Please contact Derek Sweeney to book us for a talk or training at one of your events: [email protected], +1-866-727-7555.

We love to chat with our readers about their experience with psychology in the markets and with behavioral investing! Please send us feedback on what you'd like to hear more about in this area.

Always do what you are afraid to do.
~ Ralph Waldo Emerson

And be sure to find the catalyst...
Richard L. Peterson, M.D. and the MarketPsych Team

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