Pricing Existential Risk – How Capital Markets Should Respond

In a recent memo titled “Growing risk of nuclear apocalypse“, Peter Berezin, chief global strategist at BCA Research, says that even if the probability of a nuclear conflict ending civilization in the coming year has increased (in his opinion) to 10%, investors should “stay bullish on stocks” over a 12-month horizon period. The reason for this is that, although stock prices will fall in the event of nuclear war – and could even reach zero in the event of a nuclear Armageddon – the price of all other assets will also fall (if asset markets survive.) Since you can’t hedge the risk of nuclear war, Berezin thinks you should stay long in assets that will rise in value if nuclear war is averted.

It’s certainly true that you can’t hedge the risk of the apocalypse, so it makes sense to go long on assets that will otherwise rise in value. But this proposition is not useful unless you know which assets will increase in value from their current levels if nuclear war is averted (for the time being) or if its probability is at least reduced.

Berezin argues that the actions fall into this category. But what if current (and future) stock prices are not equal to their fundamental, intrinsic, or fair value? It wouldn’t make sense to go long on stocks priced well above fair value, if you think their fair value will be restored sooner or later (even if the fair value goes up). The case for a long equity position would be fatally undermined by a market failure in which current market prices reflect a substantial underestimation of the likelihood of nuclear conflict and/or the damage that such a conflict would cause to the fundamentals that drive stock prices.

The problem with Berezin’s argument becomes apparent when considering the following two quotes from his paper: “If an ICBM [intercontinental ballistic missile] heads your way, the size and composition of your portfolio becomes irrelevant,” he wrote. “So from a purely financial standpoint, you should largely ignore existential risk, even if you care a lot about it from a personal standpoint.”

The first statement is correct, but the second is false. The fact that a nuclear war would wipe out the value of stocks (along with all other assets and the organized markets to trade them) is certainly relevant to the proper valuation of stocks in scenarios in which nuclear annihilation has not occurred. (again) produced.

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

But that’s an argument for buying or holding stocks only if their current market value is equal to their fundamental value and will continue to do so in the future. This would not be the case if markets failed to properly price existential risk because they underestimated either the likelihood of a nuclear apocalypse or the extent of damage to future earnings in such a scenario. And a similar argument could of course be made for the pricing of sovereign debt. Even triple-A instruments would fail globally in the event of a nuclear apocalypse that wipes out state institutions along with the rest of human civilization.

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

Although such denial may persist, it cannot last forever. Consider the case where no nuclear war has broken out (so far) and the bubble of denial bursts. This would be good news for humanity and the fundamentals on which stock market valuations are ultimately based. But it also means there could be a market correction (if the bursting of the denial bubble outweighs the improvement in fundamental valuation), in which case it would have been prudent to have sold the stock at discovered. Periodic deviations from market rationality underscore the need for appropriate pricing of existential risk. DM/BM

Copyright: Project Syndicate, 2022.

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