When ordinary things happen — like when Peabody Energy went bankrupt — the market reacted as one would expect. Peabody’s shares declined 99% from their 2008 peak as market participants gradually realized what was likely to happen and sold their shares. The smart, attentive, or lucky owners got out early; they sold their shares to new owners who did not see it coming quite as clearly, and these slower stockholders ended up taking huge losses. [Note that it is a bit odd to think of a singular “market” deciding that Peabody was going to go bankrupt. At every point between 2008 and the moment it went bankrupt, there was a lot of disagreement: if you believed in bankruptcy there was always someone who didn’t who was willing to buy shares from you.]
Had your pension fund owned Peabody through a standard “market weighted” mutual fund, i.e. one that owns the same fraction of Peabody as the market as a whole, it must have hurt. Your fund would not have sold any of your Peabody shares and your overall loss would have been 100% of your initial Peabody investment. [When the market for Peabody was 10% down, your fund manager would look at their shares and see that they, too were 10% down. The fund would still be weighted the same way as the market as a whole. This would remain true all the way down to zero; no adjustment would be needed to maintain a market weighting.]
Had your pension manager looked at the past stock prices, it might have hurt even worse. Based on history, Peabody had always done OK; it had always bounced back; it had never gone bankrupt before. By looking only at the past, there was no reason to believe it would go bankrupt in 2016. So, your pension fund might have tried to be clever, by investing more at the end of 2015, expecting huge profits when Peabody eventually recovered. [But, of course Peabody didn’t recover, it went bankrupt.]
To have anticipated the bankruptcy, your pension fund would have needed to look forward, towards the technical and regulatory changes that have already started to happen.
Those changes are all tied to the massive human-generated climate change that is now beginning to be obvious. We frack for fossil fuels; this puts carbon dioxide and methane into the atmosphere; these gases trap heat from the sun; the climate changes, and we are forced to adapt and/or struggle.
From a financial point of view, climate change adds three risk factors to all stocks:
- The risk of damage caused by climate change. [E.g. Miami and much coastal property is going under water eventually. We’re just not sure exactly when. Or, Canadian Forests and mining towns are burned by climate-change-associated wildfires.]
- The risk of technological replacement. This applies to many industries, but it applies especially to fossil fuel companies. The price of renewable power is dropping rapidly, and as it becomes cheaper than fossil fueled electricity, state by state, the market will remorselessly eliminate fossil fueled power plants. [In 20 years, we’ll still have some sort of cars, we’ll still wear clothing, and we’ll still have something like a phone. But, while we’ll still use electricity, probably very little of it will come from fossil fuels.]
- Regulatory risk. Just three weeks ago, on April 22, 2016, The US, China, the European Union and 174 other countries signed the Paris Climate Accord. This accord promises substantial reductions in the use of fossil fuels. It is an unprecedented international action; and it means that fossil fuel companies will never again be growth industries. [For instance, we know we need to leave about 80% of fossil fuels in the ground, if we are to keep climate change to a manageable level. Those are all on some corporation’s books as “proven reserves”. Now, who’s 80% will be left underground and become valueless? That’s a risk to any company that owns reserves of oil.]
We know that all these factors are real; those risks to your investments all exist, even though we don’t know exactly when they will become important enough for the markets to notice. As soon as enough of the market believes in them, prices will adjust. [And, if someone else understands these risks before you, they’ll sell their stock to you.] Peabody Energy may have been the first casualty of these risk factors, but it won’t be the last.
The real casualties are likely to be pension funds and 401(k) plans. In such places, fiduciaries are often trapped by the false belief that they are required to own the entire stock market, because the maximum investment diversity leads to minimum risk. [This is a somewhat complicated point and deserves a full post as a discussion, but I will note that it is a useless statement in practice. The reduction in risk comes from the fact that when you own multiple stocks, you can average away the uncorrelated fluctuations. Unfortunately, there are large, correlated fluctuations between stocks, as was observed in 1929, 1987, 2001, and 2007. So, once you have a few dozen stocks in your portfolio, you’ve gotten rid of almost all the uncorrelated fluctuations; from that point on, no matter how many stocks you add, your risk will be essentially unchanged. You’ll still be affected by stock market’s crashes.]