March 21, 2006
David Kotok, chief investment officer of Cumberland Advisors, a Vineland, N.J. shop with $800 million under management, is preparing for bird flu, which he thinks may come to the United States. Should you be doing the same? Or is the fear unjustified?
Kotok's view is one of erring on the side of caution. In an email to clients last Friday, he warned that bird flu "must be taken very seriously." He's doing no less, as our conversation with him yesterday reveals.
It's hard to know if Kotok's money-management counterparts across America share his concern, although anecdotal evidence suggests that worrying about bird flu is not yet in season. That may change, and perhaps quickly. But for the moment, Kotok appears to be in the minority within the financial community.
If you're interested in how the minority thinks on this matter, Kotok's your man. Although he's an investment professional, he's well-read on the subject of bird flu, and has talked to various officials about what may be coming. He also has definite thoughts about what bird flu means when it comes to an investment portfolio. In sum, he says that raising cash will become increasingly warranted if and when the danger signs start to rise. If the virus becomes serious enough, he thinks selling equities completely will become prudent.
For the moment, however, bird flu is still very much a foreign hazard, and so cash-only portfolios remain the stuff of disaster planning in paper form only. Time will tell if it stays that way, although the flu seems to have some momentum, as the chart below suggests. The death toll among humans, although still tiny, is growing, as is the number of countries with avian flu in animals.
Source: US Health & Human Services Dept.
Meanwhile, with the approaching migratory season of Asian birds flying to North America there's reason to worry anew, or so Kotok tells us in the following interview, which we conducted by phone yesterday, March 20. In fact, U.S. Interior Secretary Gale Norton said as much yesterday. "It is increasingly likely that we will detect a highly pathogenic H5N1 strain of avian flu in birds within the U.S. borders, possibly as early as this year," the Secretary warned, according to McClatchy News Service via Detroit Free Press.
(If you're interested in getting the government's current spin on bird flu, take a look at PandemicFlu.gov. For news reports, Google has the usual surfeit of updates. Meanwhile, sleep with one eye open, and cast a wary eye on strange ducks in your backyard.)
DAVID, WHAT ARE THE ODDS OF BIRD FLU BECOMING A MAJOR THREAT TO THE U.S. ECONOMY AND THE FINANCIAL MARKETS?
We break down the whole bird flu risk into four scenarios. There are a thousand permutations and combinations, but we boil it down to four.
Scenario one is the present level of sick birds, mainly poultry, and the spread worldwide with a very robust virus that kills them. The virus can obviously jump to a human, but to do that a person has to handle an infected bird, and come in contact with the excrement since this is an intestinal tract virus. The virus itself can survive in cold temperatures for a couple of days, so it has some robustness. There's maybe a hundred dead people around the world [from the virus], and all because they were in direct contact with the disease in a bird.
So you have a terrible threat to poultry, and the requirement to act quickly. We saw [a quick response] to the outbreak in Israel over the weekend.
Let's call the existing scenario a poultry threat with a very, very strong robust virus. We know there's evidence that migratory water fowl are carriers, so we know that ducks, geese carry without getting sick. There's lots of evidence of that. That's scenario one.
WHO GETS HURT IN SCENARIO ONE?
Obviously, the chicken industry, and some of the agriculture-related distribution-related areas.
Most people aren't changing their behavior because of scenario one, at least not yet. They view it more or less as another version of mad-cow disease, only this time it's on wings and spreading a lot faster than it is in beef.
WHAT'S SCENARIO TWO?
Scenario two hasn't occurred, but there are suspicions that it can occur. In this scenario, the virus moves from birds to other mammals--to pigs, for instance. There's evidence of sick pigs, but it's not yet clear why. But if we see it spreading in mammals, that ups the risk profile of the virus.
In that case, you're into a much larger food-supply issue. You're infecting immune systems that get closer to human immune systems, which means that the virus is constantly at work in terms of changing. Pigs, by the way, have an immune system very close to humans. So infecting pigs would be an additional warning, meaning that the impacts are larger and the risks are higher.
AND SCENARIO THREE?
If the virus becomes human-to-human transmissible. There are two possibilities as I see it, although as practical matters there are many permutations. We've boiled it down to two for Scenario three:
One, the virus is still controllable with barriers, masks, quarantines, treatment--I'd call this the SARS case study, which was a case where there was a virus, it was transmitted from human to human, and was airborne. However, you could take lots of defense mechanisms. I remember traveling in Asia and Canada, where people wore masks. While SARS had some negative economic impact--the airport in San Francisco had many unused gates--it didn't shut down the system.
Scenario three with bird flu could reach epidemic proportions, meaning that it could spread in concentrated areas. You could have a region, or a city or a country [infected], but the defense mechanisms were still working. The virulence of the disease is controllable by barrier and separation. Yes, it would be bad for air travel, bad for tourism. However, lots of the system is still functioning.
AND SCENARIO FOUR?
This is the worst-case scenario--a pandemic. Now you've got human-to-human transmission, and you've got a robust virus that's a killer. This is a horror story.
In the first world, this taxes the healthcare system and readiness systems to their limits. We've got lots of scenarios that have been constructed--the financial impact is huge, lots of dead people, healthcare systems without enough hospital beds or respirators, etc., because the handling and the servicing of the sick has to be done with masks and hazardous material suits and things like this. This is a science fiction movie that becomes real.
It doesn't take much mutation for this thing to become human to human. There are a lot of issues here, such as, you don't know what the final vaccines are until you know what the virus is, and the virus can change. Defense mechanisms take time.
Obviously, there's a lot of activity for the pharmaceutical and healthcare industries. In terms of financial markets, we're overweight the healthcare sector now. It's cheap by historical standards. We think it's a growth sector for a while, and all the bad news about certain drugs and litigation is known, and so we'd overweight the sector anyhow. But you overweight it even more as a defense mechanism against bird flu spreading human to human.
THE HEALTHCARE SECTOR IS CURRENTLY ABOUT 13% OF THE S&P 500 IN TERMS OF MARKET CAP
Yeah, I'd add five or six percentage points to that, which is pretty substantial. We're an ETF-only manager and we benchmark against the S&P 500.
On the negative side, if you add quarantine, separation, change people's behavior, you hurt tourism and the financials sector, and you introduce lots of levels of business risk. So, people become unemployed. There are lots of financial-related areas that are vulnerable--I don't think life insurers have adequate for mass deaths, for instance. How do you handle disabilities? What happens in businesses that haven't prepared, in terms of workman's compensation claims? There are a lot of issues here.
ARE YOU PREPARED AT CUMBERLAND ADVISORS?
In our office, we're inventorying masks, non-perishable foods. We're inventorying for the worse and hoping for the best.
YOU'RE PRETTY ACTIVE ON THIS FRONT. THERE'S PROBABLY NOT A LOT OF PEOPLE AT THIS POINT THINKING LIKE YOU.
I think that's changing very rapidly. For example, the Federal Reserve issued guidelines to financial institutions about bird flu on Friday. There is a very quick ratcheting up of readiness because the implications are broader than just chickens on chicken farms. I don't think anyone wants to have another bird-flu version of a Category Five storm opening a levee and finding that people aren't ready.
SO THERE'S GROWING POLITICAL PRESSURE ON PREPARDNESS?
If we have scenarios three or four, we'll have a recession. In my Scenario four, gross domestic product goes from plus-five-percent to negative-five percent at once. In the 1917/1918 pandemic, the GDP estimate shift then--based on ancient data, of course--was based on a fall of around ten or 11 percentage points.
Today, our much more intensely service-oriented economy requires socialization, which can suffer. Who would go to supermarket?
On the other side, there would be a boom in truck-based deliveries. You can go online, place an order, and it arrives outside your front door.
IN FACT, A LOT OF JOBS THESE DAYS CAN BE DONE ON THE PHONE, OVER THE INTERNET
Yes, we can work virtually.
In my office, all key people are going to be high-speed and virtually wired. We're halfway there now. We've been doing this anyway, only now we've accelerated it. Every officer in Cumberland carries a Blackberry. Everyone's got a home-to-office hook-up. We've got an off-site duplication for all records. All of that was in the works anyway. What the bird-flu threat has done has accelerated it.
Now, some people might say, "You're an alarmist, just like you were with Y2K." Okay, what happened with Y2K? I upgraded my systems. The good news: nothing happened. Meanwhile, we have much more efficient, upgraded, tested systems. Maybe that will be the case with bird flu preparation. I think [the bird flu threat] makes a bull case for tech, telecommunications, wireless--all the things that deal with virtuality rather than face-to-face.
YOU MENTIONED IN YOUR EMAIL LAST WEEK THAT BIRD FLU IS "LIKELY" TO APPEAR IN THE U.S. IN FOUR TO EIGHT WEEKS BECAUSE THE FLYWAYS OF MIGRATORY BIRDS WILL BECOME ACTIVE AS THEY MOVE FROM ASIA TO NORTH AMERICA. THE FRONT LINE, SO TO SPEAK, IS WHERE THE U.S. BORDER COMES CLOSEST TO ASIA, I.E., ALASKA.
We're tracking this quite extensively. The best information we have today is that the Asian-to-Northern American flight path, which crosses the Bering Sea, becomes active in a matter of weeks. The intense period is four to eight weeks from now.
The nearest known dead-flu bird is 30 miles from the border of the United States in the Bering Sea off the coast of Alaska. There are teams in Alaska, because Alaska would be the first line of defense. I've had conversations with Federal agents, who may not want to speak on the record--they believe that we'll see cases in Alaska within eight weeks.
THAT'S THE SPOT FOR THE PROVERBIAL CANARY IN THE COAL MINE?
Well, that would be the canary in this hemisphere's coal mine.
How the virus spreads is an issue. However, we know that migratory birds carry the virus, and some waterfowl carry but don't get the disease. As soon as you see migratory birds coming from the North, you'll begin to see transmissions in the Pacific flyway. That takes it all the way to South America and Central America and down the coast. The Federal agencies believe the return to the East Coast of the U.S. comes in the fall. Flyways tend to run North-South, not East-West.
MR. MARKET DOESN'T SEEM TO SHARE YOUR CONCERN, OR SO ONE COULD ARGUE
The market reaction is another matter. I don't think the market's pricing in anything other than Scenario one. That is, the thinking is: It's over there, not over here.
But the first dead chicken in Anchorage, Alaska is a headline in every newspaper in the United States. It's the lead story on Fox and CNN. There will then be the media stories on readiness and preparation. There are all the usual interviews. There's the Congressional circus. I'm being kind. Again, the country will listen to its political leaders, not trust them; listen to their political talk and despise them--you can quote me--and say these idiots are running our government and are making our policy and, boy, are we in trouble. I believe that will come. That will only ratchet up the fear.
What the psychological reaction will be is unknown, and how it will translate to markets is unknown.
You have a very interesting case study if you contrast Israel and France. Israel sees sick birds on Wednesday. They've got a quarantined space three kilometers wide on Thursday. Their action was triggered by seeing the sick birds....The government already had in place the process of compensation and arrangements and all of its agricultural community knew it. The farmers didn't have to worry about being bankrupted. Everyone cooperated as a team.
What's going to happen in the United States? What's going to happen when the first chicken farm in, say, Oregon, has a sick chicken? Who's going to deal with it? The local farmer? The local department of agriculture? The state of Oregon? The Federal government? Which agencies? How are they going to talk to each other? What are the arrangements in place?
WHAT HAPPENED IN FRANCE?
The biggest political issue we saw in France was the President of France sitting down to lunch, saying, don't worry, and eating chicken for lunch. The man's an idiot. A cooked chicken doesn't make you sick with bird flu. But if the people who are doing the work [with infected chickens] aren't wearing hazardous materials clothing, with the right ventilators and the right systems, they can get sick and die.
SO WHAT'S THE RISK HERE IN THE U.S. AS YOU SEE IT?
The risk in North and South America is number one a psychological one--when we start to see cases. Preparation systems in first world countries are ratcheting up, but they're not ratcheted up. And we haven't given any thought to speak of, or at least it doesn't appear that we have, to the rest of this hemisphere. You're talking to a person who's toured Third World villages in Ecuador and Guatemala, where households occupy small spaces and where children crawl on the floor, along with the chickens. This is a recipe for trouble. What's the United States going to do for itself, and what's it going to do now in its own hemisphere?
WOULD YOU OVERWIEGHT GOLD AND CASH IF THE RISKS RISE?
I wouldn't today. Today you're in scenario one. Scenario two, you begin to raise cash. You're still in animal-to-animal transmission, but more broadly so, and so the risks are rising. Scenario three, people-to-people transmission, and you raise more cash, you take become more defensive. You know you're going to have some economic slowing, and so you have only the highest-quality bonds. Credit spreads will widen, highest-quality bonds will rally. The Fed will certainly look to drop interest rates, not raise them or hold the line. The enemy is no longer inflation. And if we ever get to scenario four, which I hope we don't, you don't want to own any stocks anywhere in the world. And when I say raising cash, I would raise it mostly from emerging markets, but I would raise it globally as well, not just U.S.
No. I don't' think gold is the place you go to in deflationary, contractionary economic times. Especially when gold's $550 an ounce, not $250. So, I look for the very highest grade bonds and alter the composition of stocks. Meanwhile, I think such an experience [from bird flu] could cause the demand for energy to decline. So our overweighted energy position, which has served us well for several years, gets peeled back.
WHAT'S YOUR ENERGY WEIGHTING NOW?
We're at probably 14%-15%, and the market weight's about 10%. We've ridden this from a 6% weighting to 10%. I'd peel back.
HOW QUICKLY DO YOU THINK WE MIGHT MOVE FROM SCENARIO ONE TO FOUR, IF IT CAME?
In 1918, it appears that the pandemic was really bird flu, and it jumped in one day from the bird to the human at a farm in Kansas. That's the worst case. Remember, though, we're dealing with an unknown.
How do you assess risk with math, probabilities? You use chaos theory and shocks. You model shocks. This isn't a trendline, it's not linear.
WHAT DO YOU THINK THE ODDS ARE FOR GETTING PAST SCENARIO ONE?
I don't know. The odds are completely unknown. The odds of mutating viruses are certain, though. The effect of the mutation, and how it will operate is the unknown. The virus is already mutating. This virus in its basic form has been observed since 1997. Why is it more active now than in 1998? Birds flew in 1998. Flyways were active then. Clearly, things are happening in the virus....The virus is changing constantly. The more the virus is changing in humans, the higher the probability that a mutation will get to a human and stick. So, one of the fears here, as it's been spreading in Third World countries, is that there's more and more contact with humans.
Posted by jp at March 21, 2006 6:28 AM
want some interesting news on the avian flu panic? - go here:
Posted by: alex at March 21, 2006 2:56 PM
According to Shiller's historical data, national real housing prices dropped substantially after the 1918 pandemic.
Posted by: Lord at March 21, 2006 1:19 PM