Don’t you sometimes think that life is just as strange as a Rube Goldberg machine? You know the ones I mean; those crazy drawings of fantastically elaborate machines that link together events in implausible ways to generate some unexpected outcome. For example, at 7 a.m. a cuckoo bird emerges from an old clock, knocking a vase onto a see-saw, flipping a statuette into a fishbowl, splashing a cat that jumps from a mantle, tripping a string that turns a dial that lights a burner that cooks an egg, et voilà! You get the idea. The point is that in life, we see the cuckoo clock strike 7 a.m., but how could we ever imagine that this would lead to breakfast sunny side up? Yet so often life is just this complex.
For a timely example, take cupcakes. Or more precisely, take what appears to be the winding down of the national cupcake craze that set America on fire over the past few years. Like so many trends in American culture, this one begins in New York.
Boutique cupcake bakeries started popping up in Manhattan in the late ‘90s. In 2000, the idea that cupcakes were becoming a “thing” crystalized in pop-culture when a hit sitcom aired two of its star cosmopolitan fashionistas swapping girl talk over lavishly frosted cupcakes in a chic, Greenwich Village bakery. But as one New York based hedge fund analyst explains, the cupcake craze didn’t hit full swing until the financial crisis of 2008. She said that after the housing market collapsed, everyone in New York started eating cupcakes. The treats would turn up at the office by the dozen, piled high with buttercream in all different shades of pastel, and the worse things looked, the bigger the cupcakes got.
The cupcake craze, at least from this financial analyst’s perspective, was fueled by New Yorkers’ collective coping mechanism to the stress introduced by a traumatic event. This isn’t so hard to accept, as she also pointed out that after 9/11, everyone in New York seemed to be smoking again (in fact, a 2003 study found that nearly 1.3 million former smokers picked up the habit again following 9/11). The stress fueled cupcake craze reached such a zenith in 2011 that one cupcake bakery even IPO’d on the NASDAQ.
Simultaneously, the financial market has been making an impressive comeback. The current Bull market is one of the strongest in history, and apparently, as people are coming to terms with the fact that life didn’t end in ’08 and that, yes, they still have to go to the gym, that four-inch high swirling tower of pearlescent buttercream over genoise in the office break room is losing its allure. The proof that the cupcake bubble has burst? The lone publicly traded cupcake bakery shuttered its doors last week.
In retrospect it’s easy enough to trace a string of events back to inception. But who, besides Rube Goldberg, would ever have seen that subprime lending would lead to a housing bubble burst that would plunge the world into recession, boosting stress levels, igniting a cupcake craze, paving the way for a cupcake IPO, only for cupcakes to collapse three years later? While this is just one Wall Street analyst’s take on the cupcake craze, the fact remains that none of us are prescient enough to see how events today will affect us down the road.
Here’s one example: Home ownership has long been part of the American Dream, and has historically been thought an unassailably sound financial idea. But the home ownership rate among people 35 and under is at historic lows. Elevated unemployment rates and increasing student debt loads are obvious economic barriers to new home ownership, but analysts are also weighing the effect of psychological barriers. Many young people watched how the financial crisis affected homeowners, particularly people close to them such as parents, and analysts speculate that this contributes to a shift in attitudes, and a serious questioning of the real value of owning versus renting. How will these factors taken together shape the residential real estate markets over the next 5 years? How about the next 10 or 20 years?
Here’s another one: The Federal Reserve recently confirmed that it will end Quantitative Easing in October. After this it seems likely that interest rates will begin to rise. But what next? Could this be the first link in a chain of events that leads to the gentrification of Detroit? Or perhaps an American World Cup victory in 2018? Or a political comeback for Jesse “The Body” Ventura? Who can say?
A well-rounded risk management policy is one that plans for the foreseeable future, as well as the unforeseeable future. Understanding the interplay between known market conditions and business strategy helps plot a course through the foreseeable future. For example, when you see the cuckoo clock chime at 7:00, you can get out of the way of the falling vase. Or when you see the housing bubble burst, you can prepare for property values to plummet. But how do you go from cuckoo clock to fried egg? Or from credit crunch to cupcake bubble? Some things are just too elaborate for anyone to predict. So for the unforeseeable future, rather than speculate, we hedge.
Hedging is designed to minimize future pain by replacing uncertainty with a known and acceptable level of risk today. A healthy hedging strategy identifies the pain points you are most concerned with, and determines how to reduce this risk if conditions take an unfavorable turn. Hedging becomes necessary when you can neither predict what is coming down the pike, nor afford to be wrong. For example, if a few broken eggs is not going to be game changing for you, then you have considerable latitude in determining whether to hedge against the unpredictable as it relates to eggs. But if egg breakfasts are your bread and butter, then uncertainty about the fate of those eggs is no small matter, since you can’t afford to be wrong. Under these conditions, it’s essential to have a good hedging strategy in place to protect you against whatever zany iteration of cuckoo clock contraption, or otherwise, might put those eggs at risk.
Unfortunately, Chatham doesn’t have the financial equivalent of Rube Goldberg on staff to map out our client’s future. Anyone with that person on the payroll would never need to hedge! Instead, we have a great staff of hedging experts who can help you determine what and how to hedge to achieve the level of risk that you are comfortable with. That way, come what may, you will know that your business is sound. So if you want to talk about your hedging strategy, or just compare Rube Goldberg sketches, please give us a call at 610.925.3120 or email us.