Will Sandy blow down the economy?

All at once, the plans of men were made to look meek as one of the most powerful Atlantic storms on record roared ashore Monday night. Hurricane Sandy knocked out power to lower Manhattan, flooded the financial district and caused chaos in our nation's largest city. The superstorm cut power to about 8.1 million customers.

One early estimate put overall damage and lost business at roughly $50 billion; that could grow once those miles of subway tunnels are drained of seawater and an army of insurance adjusters puts boots on the ground.

But Sandy will hit the economy in much deeper ways. No, we're not anywhere near the impact from the earthquake/tsunami/nuclear meltdown that hit Japan last year. But given the fragile state of the economy, Sandy could pull growth of the gross domestic product down from 2% toward 0% in the months ahead. Over six months, that could be a loss of output of roughly $140 billion

Combined with other negatives, from the looming "fiscal cliff" in Washington to the ongoing European debt crisis, this will only make life tougher for investors. Here's where trouble will arise, as well as a few ideas on how to protect yourself:

The direct costs

I see three big ways Sandy will affect growth.

The first is through the economic losses that come as damaged and flooded cars are scrapped, furniture is thrown out and subway systems repaired. Initial estimates from Eqecat put this drag at $20 billion -- far from the $280 billion losses incurred in the triple-threat Tohoku disaster in Japan last year. Still, if these initial estimates are correct, Sandy will be the fifth-worst hurricane on record, accounting for inflation, according to the Insurance Information Institute.

In the context of other recent disasters, Sandy is roughly equivalent on this measure to the Russian wildfires caused by the heat wave of 2010, which destroyed nearly 3,000 buildings. (The human toll was much higher in Russia, though, with more than 50,000 people killed).

Both Japan and Russia took hits to their GDP growth rates a result of those disasters. Russia's growth dropped from 1.7% in the second quarter of 2010 to 0.3% during the disaster, before bouncing to 2.3% in early 2011. In Japan, the growth rate plunged to negative 2% before rebounding late last year as government rebuilding efforts revved up. 

The consumer impact

The more important consideration, and the one that I think will be have the larger impact on the U.S. economy, is Sandy's influence on consumer sentiment heading into the critical holiday shopping season.

Already, shoppers have been propping up the economy up as businesses pull back. Manufacturing activity has stalled. New orders are down. CEOs have cut back on plans to invest and hire. Inventories are down.

The regional Federal Reserve manufacturing activity reports make for depressing reading. The latest out of the Dallas Fed shows a nasty combination of rising materials costs and plunging new orders.

Yet in the latest report, the Conference Board's Consumer Confidence Index has jumped back above the 70 level (1985=100) for only the third time since the recession ended. More consumers are making plans to buy things like cars, appliances and televisions.

Credit Suisse economists note this is a big reversal from the early stages of the recovery as GDP categories like housing and consumer durables spending have "punched above their weight in the recent quarter" while "business investments and exports have slackened."

To put it in numbers, consumer spending jumped 2% and residential investment surged 14%, while business investment dropped 1.3% and exports fell 1.6%,

The key in all this is that households remain unconcerned about the fiscal cliff -- the package of tax hikes and spending cuts worth some 5% of GDP set to hit on Jan. 1 unless Washington acts. CEOs are acutely aware of it. CEOs tend to have a better read on the situation during major economic turning points. They were nervous in the middle of 2007 before the recession and financial crisis struck, and they were confident in mid-2009 as the recovery was starting. Households were confident in 2007 and nervous in 2009.

I've been expecting consumer confidence to come down later this year as the media starts covering the fiscal cliff in earnest in November and December -- after the election. Sandy's impact could pull it down even sooner, dragging on GDP growth in the fourth quarter.

Again, the Japanese experience is illustrative. Consumer confidence dropped hard from 40.6 during the March 2011 disaster to a low of 33.4 two months later as people watched the mismanagement of the Fukushima reactor meltdown and the slow pace of rebuilding. Consumer spending cooled, as did retail sales. On a year-over-year basis, sales dropped 8.3% in April of 2011 and an additional 4.8% that May.

A similar, if less severe, drop is likely as America's most populous city recovers from record flooding, fires and power outages. Experiences like these lay bare just how fragile modern society is and how quickly things can devolve. Since the economy lives and dies by decisions made on the margins, it's hard to see how this won't have a negative impact as people decide it's best to save a little more rather than splurge.

The stock market bite

The final piece to the puzzle is the impact on the financial system from the New York Stock Exchange's longest weather-related closing since the Blizzard of 1888. Again, confidence plays a role here, because illiquidity risk -- the inability to buy and sell -- has a direct negative impact on the valuation of financial assets. This is especially true with Wall Street trying to prepare for major, and by nature unpredictable, political events: the presidential election and the fiscal cliff.

The New York Stock Exchange reopened trading today. That was critical, since it was the last trading day of the month, a time when institutional investors like hedge funds and mutual funds conduct "window dressing," which means buying and selling to clean up lists of holdings before statements are presented to clients. (You don't want them to see losers; think of it as erasing the bad grades from your report card.)

There will surely be fireworks ahead, especially with technical measures of market strength weakening so badly even before the weather-related break. Last Friday, the Nasdaq 100 Index ($NDX) dipped its toe below the critical 200-day moving average for the first time since December, as selling pressure intensified. Safe-haven inflows were pushing up Treasury bonds. And money was flowing out of key, economically-sensitive stocks, especially in the energy sector.

In Everybody's Magazine, Edwin Lefèvre, a financial journalist active in New York in the early 1900s, described the way illiquidity deepened the Panic of 1907. While this was obviously much worse than the NYSE's flood closure, from a market perspective, it reflects the same feeling of helplessness:

"(O)ne cloudy day somebody asked for a dollar, and, not getting it promptly enough, very promptly squealed. That squeal was the signal for the chorus to join -- the chorus of the entire world, which also wanted Money! Money!MONEY! It is sad to want money and not get it. But to ask for your own money and not get it is the civilized man's hell."

How to hang in there

For now, my advice to my readers (and my clients) remains the same: Stay defensive with large cash allocations, and use targeted short positions such as the ProShares UltraShort Oil & Gas (DUG) exchange-traded fund, and Treasury holdings such as the Direxion Daily 20+ Year Treasury Bull 3x (TMF) ETF, to try to find gains. Both positions will do well if the selling pressure intensifies, sending investors scrambling for the proverbial high ground of Treasury bonds.

I am also recommending outright short selling in some stocks -- including Hercules Offshore (HERO) -- to take advantage of any pull-downs in crude oil prices. (See current positions in my Edge Letter Sample Portfolio.)

If there is a silver lining from Hurricane Sandy, it's that academic research shows that natural disasters have a long-term positive effect on growth. That's because they encourage fresh investment and the adoption of new technologies, and they drive increases in productivity. If anything could use this, it's the New York City subway and transportation system.

So while the country and its greatest city will surely bounce back, there's first going to be turbulence for the economy and the markets. Investors will need to stay nimble and heed the warnings.

At the time of publication, Anthony Mirhaydari did not own or control shares of any company or fund mentioned in this column. He has recommended ProShares UltraShort Oil & Gas and Direxion 20+ Year Treasury Bull 3X ETFs and shorting Hercules Offshore to his newsletter subscribers and money-management clients.

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