What North Korea's missiles really mean for the market

What North Korea's missiles really mean for the market
North Korea's intermediate-range strategic ballistic rocket Hwasong-12 lifting off from the launching pad at an undisclosed location near Pyongyang on August 30, 2017.

During the past few months, many clients have asked how we feel about the market risk related to the launch of missiles by North Korea. This question and similar ones about geopolitics have become more common than at any time since the financial crisis.

Therefore, it seems useful to articulate our approach to the risk embedded in macro and geopolitical incidents.

While the number of major economic, geopolitical, or environmental events that occur today of the scale which rattle world markets may not be greater than the past, one factor is definitely true: we are more geo-centric as a society.

The dissemination of information on each phenomenon, whether it's a coup, earthquake, hurricane, terrorist attack, currency collapse or deadly virus, is both immediate and ubiquitous thanks to the internet and social media.

Disturbing images of world events capture much more of our consciousness today, since they are virtually unavoidable. While it would seem obvious that this "mind-share grab" alone would affect trading patterns, sentiment and confidence, we, amazingly, have not seen an overall increase in downward moves following disastrous or alarming situations.

One way to think about the stock market is as an open forum of thousands of buyers and sellers who collectively set the price for each stock as the present value of the stream of expected future earnings.

This process incorporates all the risks that these multitudes of traders perceive.

After 9/11 some investors believed that the market began to embed a new "terrorism" discount to all financial assets, due to this previously unrecognized risk. Since 2001, we have witnessed a steady stream of both terrorist attacks and natural disasters (earthquakes, tsunamis and hurricanes) across the globe.

If the market adjusts to each new reality, it is reasonable to assume that its discounting methodology now includes a broader range of external dangers.

If we look at some cases of the market response to "crises" over the past several years, one sees how the selloffs are followed by returns to prior levels. As an example, following the two recent missile launches by North Korea, the S&P 500 dropped only 2 per cent, and recovered almost immediately.

The table suggests that these occurrences, some of which have been horrific in terms of human tragedy, have a relatively contained negative effect on the market. The reason may be that stock exchanges react principally to the disruption of national or global economic activity and profitability.

While fifty inches of rain in Houston has enormous personal and financial consequences for the local economy and its inhabitants, the economic impact is considered limited in terms of scope and duration.

We might ask whether the S&P 500, which trades at a relatively high multiple of 17 times forward earnings, is truly incorporating these risks properly. On the other hand, one could argue that technological advances have reduced some of the uncertainties formerly associated with investing.

For example, there is much better reporting and financial information available to analyse. Corporations benefit from faster communications, superior production methods, infinitely better sales and customer tracking, and highly sophisticated logistics efforts, all of which eliminate some business risk.

The key drivers of stock valuation, however, are the underlying earnings trajectory of the public companies in which we invest. This is where we spend the majority of our time.

Rather than focusing on the potential, and, in most cases, limited market effect of exogenous, unpredictable events, we need to be most concerned with the level of the overall market and the specific pricing of the stocks in our portfolios.

If we anticipated that earnings were rolling over, we would be increasingly worried, but this is not a scenario we see on the horizon.

Commentary by Karen Firestone, chairman and CEO, Aureus Asset Management.

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