As Hurricane Dorian begins to affect the East Coast, what does historical analysis of past storms tell us about risk mitigation?
Our thoughts and prayers are with those affected by Hurricane Dorian. The safety and well-being of our loved ones is the most important thing at a time like this.
Beyond the threat to those people in the storm-path itself, natural disasters such as hurricanes can affect our investment markets. But to what extent? To what degree should an investor take any action based on a massive weather event?
Questions like these are what prompted John Jagerson, editor of Strategic Trader, to conduct a market study over the weekend, looking at hurricanes within an historical, market context.
At this point, I’m going to turn it over to John to present his analysis and findings. Afterward, I’ll circle back to ask some follow-up questions based on John’s essay.
Once again, and most importantly, our best to all those impacted by Hurricane Dorian.
***The short and longer-term impact of hurricanes on the investment markets
As Hurricane Dorian bears down on Florida and the East Coast of the U.S. we are all hoping that the costs in life and injuries can be kept to a minimum. However, it seems unlikely after record windspeeds in the Caribbean last weekend that there won’t also be a heavy toll here in the U.S. as well over the coming days.
Events like Dorian can be difficult for investors who are rationally much more concerned with making sure family, friends, and coworkers are safe than in worrying about the portfolio impact of storms. However, some historical analysis can still be helpful for investors looking for ways to plan around the risks presented by these extreme weather disasters.
Conventional wisdom suggests that storms are bad for insurance companies and the market averages, but good for home improvement, building materials, and oil refiner stocks. Storms drive up demand for home and building repairs and naturally constrains the supply of energy products which can increase their price.
As usual, some of the “conventional” thinking investors use to make investment plans around storms can be misleading or just plain wrong. I looked at the 11 most damaging storm systems to hit the U.S. over the last 15 years starting with Hurricane Katrina and ending with Michael in 2018 to better illustrate the typical effect a major natural disaster has on the market.
***Should you worry?
The impact on the major averages from a major storm is too diffuse to quantify. The impact of other events can further disguise the impact of storm damage. For example, 2012’s Hurricane Sandy was incredibly damaging to life and property, as was 2011’s Irene, and they coincided with large drawdowns in the market. However, both storms happened at the same time market events like the U.S. Fiscal Cliff and European Debt crisis were already hurting valuations.
The trio of Maria, Irma, and Harvey that hit in 2017 would have been expected to have a big impact on market prices in September of that year. The three hurricanes are now in the top five most damaging storms to ever hit the U.S. and yet the S&P 500 experienced barely a blip during the weeks the U.S. coasts were lashed by the storms.
The short answer is that, historically, there is almost no reliable statistical relationship between storm damage and the major indexes. Investors focused on keeping family and property safe during the storm can at least save their mental energy from worrying about their portfolio as well.
***Are there opportunities?
Most technical analysts (like myself) believe that investors are inherently irrational to a certain extent. The tendency to oscillate between extremes of overpricing or underpricing unexpected events creates opportunities for savvy investors to sell at highs and buy at lows, respectively. Storm cycles like Dorian aren’t expected to impact the market averages, but some sectors and individual stocks are more sensitive to the storms and exhibit reliable patterns investors can take advantage of.
In my studies, the three asset classes or sectors that have the most reliable patterns are gasoline prices, home improvement stocks, and property insurance companies. Within the week prior to a storm hitting U.S. coasts, gasoline prices start to rally for an average short-term gain of 11%. I was surprised we didn’t see more movement last Friday in gasoline prices, but that could easily change before Dorian leaves this week.
Home improvement and building materials stocks follow the same pattern of gasoline prices for average short-term “storm gains” of 7% while property insurance companies like Chubb (CB) begin a short-term decline of -5%. The key phrase for all three asset classes is “short-term” because irrational investors tend to persistently overprice the impact of the storm.
For example, from the time Hurricane Harvey was designated a Tropical Storm on August 17th 2017 until the third storm of the season, Hurricane Maria, dissipated on October 2nd 2017, gasoline prices rallied more than 22% and then gave up 11% as investors arrived at a more rational valuation of the impact of the storm system on energy prices.
I recommend that investors keep their priorities in mind during storms and focus on what’s most important; however, the over-and-underpricing whipsaw can be an opportunity for profits. Traders should avoid the highs that occur in the middle of a storm as a buyer, but potentially plan to take advantage of the highs by selling calls against long positions or taking profits as a seller if possible.
These whipsaws are usually followed by longer-term gains in home improvement and building materials stocks after the initial price spike has cooled. This can give investors a chance to take advantage of new demand when prices are at a low rather than chasing the initial rally.
Historically, the longer-term impact on insurance companies is more erratic, and this year I wouldn’t expect a quick rebound even if some over-selling occurs. A huge percentage of insurance profits is derived from conservative investment portfolios managed by insurance companies against future claims. As interest rates fall, those profits are also falling, which means hurricane Dorian is only going to compound those negative trends. I think investors should avoid this sector right now regardless of the storm.
***Follow-up questions for John
Jeff here. After I read John’s piece, I asked him a few follow-up questions …
Jeff: Can the damage from a hurricane really affect the profitability of a major corporation like Home Depot — to the extent where it warrants considering such a company in your portfolio?
John: Yes, however, you have to be careful. What usually happens is that home improvement stocks will spike as the storm nears the coast, which is basically what happened last week, but then it retraces some of that initial spike once the storm hits and the damage can be assessed. Usually, a week after the spike prices have come back to near where they were before the storm, which is the buying opportunity for longer-term gains.
NOTE: Below are the chart for Home Depot and Lowes, respectively. As you can see, at the time of this writing (Tuesday morning), Home Depot has climbed 3.6% over the last six trading days, while Lowes is up 5.2%. Both are pulling back as I write.
Jeff: Was there any correlation between the category of the hurricanes you studied, and any related impact on the market or specific sectors?
John: There isn’t a good linear relationship between the strength of the storm and its effect on stocks. It all depends on where the storm hits and how long it stays. For example, Sandy was the 3rd most destructive Atlantic storm on record but it was just a category 3. Hurricane Agnes in 1972 was the 10th most expensive storm but was only a category 1.
Jeff: By the time our Digest file reads your study, I’m assuming they will have missed much of the run-up in prices of certain sectors that seems to accompany the “week prior” time-period that you referenced in your study. Does that mean a trader is too late to act on your findings?
John: A short-term trader would have wanted to buy in last week once news of the storm was building. However, short-term traders looking for quick profits are going to want to be ready to sell this week when the initial price spike peaks. Very aggressive short-sellers might try to short that “retracement” this week as well.
Jeff: As you see it, for an investor wanting to factor in the effects of Dorian into his/her portfolio, what are the specific, appropriate steps?
John: Two things: First, investors who are long stocks like Home Depot or commodities like gasoline may want to target taking profits off the table this week before the spike runs out of steam and take some of those initial windfall profits off the table.
Two, the bullish effect on home improvement and building materials stocks usually rebounds after the initial spike is corrected. That usually takes place the week the storm starts to dissipate, which looks likely to be the week of September 9th.
Jeff: It seems your analysis is suggesting insurance companies could be hurt by this. Would getting them out of your portfolio, or even buying 6- or 12-month puts on select insurers be something to consider?
John: Yes, I think so. To be frank, even without a storm, I would probably think that was a pretty good idea anyway. This low-rate cycle is going to hammer their profits pretty hard. That will be particularly true for life insurance companies — many of which look very overvalued to me right now.
Jeff: Thanks, John.
To read more from John and learn about his Strategic Trader service, click here.
On the topic of insurers, as I write, Dorian appears to be on a path to skirt much of the eastern seaboard. Given this potential for more damage, analysts at UBS have updated their model to reflect wider insurance losses, raising their base case to $25B from $15B.
To all those in Dorian’s path, our thoughts and prayers go out to you. Far more important than anything related to the markets, please be safe.
Have a good evening,