How should capital markets respond to an impending apocalypse?

In a recent note titled “Rising Risk of a Nuclear Apocalypse”, Peter Berezin, the chief global strategist at BCA Research, argues that although the probability of a civilisation-ending nuclear conflict in the coming year has risen (in his view) to 10%, investors should “stay bullish on stocks” over a 12-month horizon. The reason is that, although stock prices will fall if there is a nuclear war – and could even reach zero in the case of nuclear Armageddon – so will the price of every other asset (if asset markets survive). Since you cannot hedge the risk of a nuclear war, Berezin thinks you should stay long on assets whose value will rise if nuclear war is avoided.

It is certainly true that you cannot hedge apocalypse risk, and that it therefore makes sense to go long on assets whose value will otherwise increase. But this proposition is not helpful unless you know which assets will go up in value from their current levels if nuclear war is avoided (for the time being) or if its likelihood is at least reduced.

Berezin argues that stocks fall into this category. But what if current (and future) stock prices are not equal to their fundamental, intrinsic, or fair value? It would make no sense to go long on stocks at a price far above fair value, if you believe that their fair value will be restored sooner or later (even if fair value increases). The case for being long on stocks would be fatally undermined by a market failure in which current market prices reflect a substantial underestimate of the likelihood of nuclear conflict and/or of the damage that such a conflict would do to the fundamentals driving stock prices.

The problem with Berezin’s argument becomes apparent by considering the following two quotes from his article: “If an ICBM [intercontinental ballistic missile] is heading your way, the size and composition of your portfolio becomes irrelevant,” he writes. “Thus, from a purely financial perspective, you should largely ignore existential risk, even if you do care about it greatly from a personal perspective.”

The first statement is correct, but the second is wrong. The fact that a nuclear war would wipe out the value of stocks (as well as all other assets and the organised markets for exchanging them) is surely relevant to the proper pricing of stocks in scenarios in which nuclear annihilation had not (yet) occurred.

The fundamental, intrinsic, or fair value of a company’s stock is the (risk-adjusted) present discounted value of the stream of expected future dividends and other payments. That fundamental value would indeed go up if the likelihood of nuclear annihilation were to fall in the coming weeks and months. In this scenario, a future in which there would be no profits (and in which the investor would be unlikely to survive) would become less likely, while a future with positive profits would be more likely.

But this is an argument for buying or holding stocks only if their current market value equals their fundamental value and will continue to do so in the future. This would not be the case if markets failed to price existential risk correctly because they underestimated either the probability of a nuclear apocalypse or the magnitude of the damage to future profits in such a scenario. And a similar argument could of course be made for the pricing of sovereign debt. Even triple-A instruments would default comprehensively in the event of a nuclear apocalypse that wipes out the institutions of the state along with the rest of human civilisation.

When I noted recently that markets are in denial about nuclear risk, I was making an argument about market failure. My worry is that markets are underestimating both the likelihood of an all-out nuclear war and the impact that such an event would have on the future streams of corporate profits. If this assessment is correct, today’s stock markets are overpriced. There is an apocalypse-denial bubble.

Though such denialism can persist, it cannot last forever. Consider the case where no nuclear war has erupted (thus far) and the denial bubble bursts. That would be good news for humanity and the fundamentals upon which stock market valuations are ultimately based. But it also means there could be a market correction (if the bursting denial bubble trumps the improvement in the fundamental valuation), in which case it would have been prudent to have shorted stocks. Periodic departures from market rationality underscore the need for proper pricing of existential risk. DM/BM

Copyright: Project Syndicate, 2022.

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