Chasing Storms

The movie “Twisters” is a reboot of one of the best disaster movies ever made. It features a fleet of beautiful Dodge Ram trucks and some of the best special effects I have ever seen. The full theater experience, complete with surround sound, made the power of each storm pop right off the screen. The film was also surprisingly informative about how these storms form and the difficulties of living in an area where such natural disasters are common.

After watching the film, I have no idea why anyone would want to live in Tornado Alley. This unofficial region in the central United States runs from northern Texas up to South Dakota and spills into neighboring states. The 500,000 square mile area produces the highest percentage of tornadoes globally and is home to some 20 million people.

So, I did some digging. What I learned was that despite the intense special effects in the movie, the real frequency of devastating storms is surprisingly low.

Thanks to some data from Wikipedia, we can see that EF0 and EF1 tornadoes make up 89% of all tornado activity in the U.S. This means that an overwhelming majority of tornadoes are like what we see throughout most of the movie—something that can be chased by thrill-seekers without much fear of catastrophe.

But what about the other 11%? The EF Scale (Enhanced Fujita) accounts for the wind speed of the storm, while seeking to measure the level of destruction.

Now, I also understand the irony of me saying this while working in the financial markets. The stock market especially can feel like the weather, sometimes it rains and sometimes it’s all sunshine. Either way, totally unpredictable. This has gotten me thinking: what do storms look like in investing? Can we create our own way of looking at the financial storms that have occurred in the past?

This August, we had a mixed earnings season, which saw a slight decline off the market’s highs. Stocks were punished for missing earnings more than average, according to FactSet. As 2nd  quarter earnings were reported, the cumulative effect of positive and negative reports caused the market to decline in an orderly fashion. And then, seemingly out of nowhere, the Japanese Federal Reserve announced they would raise interest rates, causing global markets to melt down over two weeks. Between the two stories, it was a financial tornado.

In fact, by our measurement, it was an SP2 tornado (see what I did there?), bottoming out at roughly -8.5% off the July highs. It was one of only 23 such storms that have caused as much destruction since January 1, 2019.

I looked at rolling 10-day returns, where the total return was negative, and created our own version of the EF scale. We can see that only 5% of rolling 10-day periods can be classified as SP2 financial tornadoes. Compared to the frequency of EF2 tornadoes at 8%, 5% is a slight improvement over the real natural phenomenon. Taking this further, just like tornado season or hurricane season, a chart of total storms can make things seem worse than they actually are. Across all 10-day rolling return periods, the market was only negative 40% of the time. The 23 storms happened just 1% of the time. As a reminder, the markets have been quite turbulent since 2019, enduring several large military conflicts, a global pandemic, and global inflation.

This does not mean the risk taken when investing is overblown. If a tornado razes your house, it can take years to recover from the fallout. In late 2007, the Great Recession saw the largest tornado hit U.S. financial markets since the Great Depression. It took five years for markets to recover.

So, what do we do with all this information?

Financial tornadoes don’t happen every day. As you will see in Andrew’s piece below, historically, a 10% correction happens once every two years. We cannot know or control when the next financial storm will hit, but we can take precautions. Proper diversification and cash reserves can act as storm shelters. Managing cash flow and leverage can strengthen your structure. A good community can help you bounce back from hardship. Perhaps the best we can do is hope for the best and plan for the worst.