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September 19, 2018
Please read the important disclaimers at the bottom of this post. Past performance is not indicative of future results. Not a recommendation to buy or sell securities. Nothing in this presentation is intended to be construed as investment advice.

We are a little late with our monthly piece this time. As most of you know, weather forecasters last week indicated that Hurricane Florence would pass right over us on its way inland. To be sure, a direct hit of the Category 4 storm on this area would bring catastrophic flooding and significant property damage. We spent several days last week reviewing Martello’s disaster recovery procedures, making sure we had backup plans in case we couldn’t make it to the office to trade, and buying cans of sardines. As fate would have it, a high-pressure system caused Florence to weaken materially and its path to shift southward, sparing our area from a direct hit but causing damage, flooding, and unfortunately loss of life in the Carolinas instead. Our hearts go out to those affected by this massive storm and we encourage everyone to find ways to help those affected by the devastating flooding.

One of the staggering things about any severe storm, but particularly a hurricane, is the extent to which the approaching event puts on display the fragility of our modern lives. Think about the convenience that we have been able to engineer as a society. Think about the convenience of the world’s historically most precious commodity, potable water, and how you can just purchase it in a small handheld bottle for just over a dollar at the corner store. But within 24 hours of the first report that Florence would impact our area, most stores had entirely sold out of regularly priced water. Sure, you could make it through Florence on Evian or Perrier if needed, because “premium water” was still available, but water that most people would typically buy was not. This is a pattern I observed nearly every year as a kid growing up in South Florida and have continued to observe with hurricanes here in Hampton Roads.

There seem to be technological and psychological factors that are converging to arrive at this “run” on water – and other products as well – every time a rough weather pattern nears. Modern-day supply chains have evolved into a just-in-time model where the supply chain reacts almost immediately to consumer demand and pushes product out to the store when it is needed. This helps the store avoid stocking too much of any product for too long. These efficient systems have undoubtedly been built with the ability to predict future demand based on historical demand (say, chocolate deliveries increase around Valentine’s Day before the stores come close to selling out). But currently, the lag is a bit too long and the demand too high when it comes to restocking emergency staples. There’s never enough bread or milk in a snowstorm. On the psychological side, this is an excellent example of a “short-volatility” mindset in practice. The system is built for, and consumers are accustomed to, the continuation of normalcy. As I mentioned, clean drinking water is probably the most precious commodity in the world. Yet, our society depends on and expects its limitless and (nearly) free availability at the turn of a tap. The prospect of a major hurricane, surely a volatility event in weather terms, puts these dependencies to the test, causing people to stampede for the few remaining bottles as they wrestle with the reality that no system can engineer away the unexpected.

I’m not a prepper by any stretch, but even I know that it would be incredibly easy for most people to insure themselves against a prolonged period without water. Based on the results of a simple web search, a single person could avoid this scenario with a mere $10 investment, which would buy them about 6 gallons and 6 days of water. For a family of four, the cost is even less per person since you can get a better price for buying in bulk. Why then, do so few people choose to insulate themselves from this possibility? It’s near chaos in the water aisle as the weather approaches. It’s not for lack of warning. These events happen once or twice every year, and it’s the same thing each time. Sure, it would be easy to point to the money required or the wasted space in the cabinet/garage, but the simpler answer is that most people don’t worry about it until the storm is on the way. They’re used to the engineered conveniences of modern life. This is what I meant by the “short-volatility” mindset. By not preparing for such an event ahead of time, the water-bottle-less are betting that an event will not happen, or that even if it does they will be fast enough to the store to guarantee their supply.


We have discussed short-volatility often and in many forms, from the explicit (inverse vol products and strategies) to the implicit (correlation assumptions). To be fair, the short-volatility mindset is proven right most of the time—most days, the hurricane won’t come, there will be enough water, the market won’t blow up, and stable correlation assumptions will hold. It is the unforeseen catastrophe, though, that challenges these assumptions, be it a hurricane or a market shock. Charlie and his wife have an infant son and when they heard the hurricane was coming, they found a hotel with a backup generator and a concrete structure and paid up for it. It went unused after all, but this physical insurance policy was necessary for their peace of mind. This characteristic of shocks being unexpected, rare, and calamitous leaves managers in constant search for the most cost-effective and efficient hedge. In markets, hedges are typically very costly and inefficient. For example, the cost associated with rolling protective put options to protect an equity portfolio is typically prohibitive, as it eats up most of the expected return of a stock portfolio.

Still, for most investors, some form of protection is required in attempt to combat negative outcomes. The thought of a storm-induced water supply emergency highlights one kind of systemic fragility. Luckily, ten bucks and some wasted pantry space is a very cheap hedge. In markets, though, it is pretty much impossible to time the next shock or know where it will come from, but a good guess would be the debt market. By nearly every metric (Business Debt/GDP, Federal Debt/GDP, Margin Debt/Disposable Income), the US is more indebted than at any other time in history, as is a solid chunk of the developed economies globally. A few months ago, we highlighted statistics showing the increased leverage in the investment grade corporate bond market and discussed the potential systemic shock of a widespread ratings migration in the next recession. In addition, credit spreads remain historically tight in high yield fixed income and covenant-lite leverage loan issuance continues to boom, both of which reflect investor optimism about even the least creditworthy borrowers despite record indebtedness across the economic spectrum.

With a potential storm brewing and many forms of hedges prohibitively expensive, many investors are left in a bind about how to best protect their portfolio from potentially large losses in the next downturn. Though it’s pretty much impossible to time the turn of a cycle, we can use disciplined processes to assess opportunities and risks. We’ve highlighted the benefits of this approach in many past posts; suffice it to say we believe that vigilance is more critical now than ever. We know that, despite bullish trends and some positive economic releases, clouds are forming around valuations and debt. As stated above, we are all wired to assume a continuation of normalcy. It’s important to keep at front of mind, though, that valuations are stretched to levels historically only associated with some of the worst crises in US history. At the same time, the system is more levered now than ever. Additional leverage means additional risk, period. This dangerous combination of factors calls for focusing on the risks embedded in a portfolio and looking to reduce exposures at the first sign of trouble. When the forecast calls for clear skies ahead, and it certainly will at some point, we can shift our focus to capitalize on the many opportunities that will surely be available.

We appreciate your time and interest. Please feel free to reach out with questions or feedback, we would certainly enjoy hearing from you. As always, we wish you great health, many successes, and the wisdom to throw a few gallons in the garage for safe keeping!


Arthur Grizzle & Charles Culver
Managing Partners
Martello Investments

important disclaimers

The information contained in this presentation is qualified in its entirety by the following disclosures which must be read in conjunction with the presentation. The presentation is intended for sophisticated investors for informational purposes only and is not intended to constitute investment advice or recommendations by any party. Unless otherwise indicated, information, data, strategies and opinions included in the presentation are provided as of the byline date and are subject to change without notice. In accordance with relevant SEC advertising regulations, a full list of trades and investment recommendations is available upon request. Past performance is not a guarantee or a reliable indicator of future results. The views and strategies described herein may not be suitable for all investors. You should consult your financial advisor regarding such matters. The material contains the current opinions of the author, and such opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based on proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. This material contains information that has been prepared from original sources and data believed to be reliable. However, no representations are made to the accuracy or completeness thereof. Investing involves a variety of risks and may be only appropriate for sophisticated persons who can afford a loss of all or a substantial portion of their investment. No part of this material may, without advance written consent, be copied or duplicated in any form by any means. There can be no assurance that any client’s investment objective will be achieved or that a client will not lose a portion or all of its investment account. The investment return and principal value of any investment will fluctuate over time. No chart, graph, or other figure provided should be used to determine which investment strategies to use or which securities to buy or sell. No figure above should be taken as a recommendation or endorsement of a specific security, sector, or strategy. References to market or composite indexes, benchmarks or other measures of relative market performance over a specified period of time are provided for information only and do not imply that any client account will achieve similar returns, volatility or other results. The composition of an index may not reflect the manner in which a client’s portfolio is constructed in relation to expected or achieved returns, portfolio guidelines, restrictions, sectors, correlations, concentrations, volatility or tracking error targets, all of which may change over time. An index’s performance does not reflect the deduction of transaction costs, management fees, or other costs which would reduce returns. You cannot invest directly in an index.

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