It's not the war, it's the wait
Traders are holding their breath and the markets are tanking, but a study of past conflicts shows that stocks are almost always back on their feet in a few months. For a long-term investor, this is only a blip.
By James B. Stewart
"War is at best barbarism," General William Tecumseh Sherman admonished the graduates of the Michigan Military Academy in 1879. "It is only those who have neither fired a shot nor heard the shrieks and groans of the wounded who cry aloud for blood, more vengeance, more desolation. War is hell."
Not many would disagree, not after an intervening century that witnessed the devastating effects of two world wars and countless other tragedies, large and small. Nor have recent experiences with high-tech weaponry, which to some extent has shielded American soldiers and their allies from the immediate horrors of war, done much to change the popular perception.
So it's understandable that U.S. investors, too, tend to see war as another kind of hell, one that plunges share prices into a tailspin, disrupts the global economy and throws a dark shadow over the future. War may be first and foremost a military event, but it's also an economic event with potentially profound implications. Some of the earliest voices arguing against a U.S. invasion of Iraq came not from idealistic pacifists, but from Wall Street itself. The prospect of war shadowed the markets throughout 2002 and early 2003, cited constantly as a factor holding down prices.
Markets weather crisis just fine
Even bullish outlooks for 2003 were full of disclaimers. Edward Kerschner, chief global strategist at UBS Warburg and one of the more thoughtful economic forecasters on the subject, advised clients, "Only if an attack on Iraq were to change today's environment-of modest economic growth and close to zero inflation-would a sharp and sustained decline in stock prices seem likely. But even though any attack on Iraq would likely have only a mild direct impact, it is not unreasonable that it could derail a fragile recovery scenario."
Curiously, however, the historical record doesn't support the common hypothesis that war is bad for the stock market. A study by Ned Davis Research looked at 36 crisis events, most war-related, beginning with the World War I, triggered closing of the stock exchange in 1914 and continuing through the Enron (ENRNQ, news, msgs) testimony before Congress last year. It found that during a crisis, the Dow Jones industrial average ($INDU) fell an average of 6.4%. But right after that, the market rallied -- an average of 3.9% after 22 trading days, 5.1% after 63 and 9.1% after 126.
Only seven times out of the 36 crises did the stock market wind up lower after 126 days than it was before the crisis period.
It's not the war, it's the waiting
Why this would be the case is perhaps less mysterious than why the perception to the contrary is so widespread. War is an expensive undertaking, and it has generally provided a strong macroeconomic stimulus in the form of higher government spending. In the Keynesian view, spending and employment associated with World War II, despite the horrifying destruction wreaked on Europe and Japan, led the world out of the Great Depression. The economic infrastructure of America emerged unscathed by combat on continental soil. The Vietnam War may have been a military and foreign-policy disaster, but the spending to support it helped fuel the bull market of the late '60s.
Most military crises are, by their nature, a surprise when they happen, yet some have been widely predicted. Hitler's invasion of Poland in 1939 may have been a shock, but some kind of conflict involving Germany had been expected. So, too, with the Japanese bombing of Pearl Harbor. The U.S. attack on Iraq after its 1990 invasion of Kuwait came as no surprise; President Bush had given Saddam Hussein a very public ultimatum. Yet there doesn't seem to be any obvious correlation in the research between the amount the market changes during a crisis and the foreseeability of that event.
My own suspicion is that the prospect of war, rather than war itself, exerts a strongly negative psychological effect on investors. After all, war can and often does have dire consequences, even if they aren't primarily economic. Fertile imaginations can easily conjure up worst-case scenarios, and the media, as it should, explores these in abundant detail. I recall many of the dire predictions that preceded the 1991 Gulf War: that Iraq would unleash weapons of mass destruction; that its vaunted Republican Guard would prove a challenge to U.S. troops fighting on unfamiliar terrain; that oil supplies would be cut off, triggering an energy crisis; that the Middle East would be plunged into chaos. With the exception of the Republican Guard, which has never regained its reputation, I heard the same warnings this time.
Nothing short of defeat seems to wound
Of course, hindsight always provides the comfort of certainty. No one can say for sure what the result of any conflict will be. But market history suggests that just about any outcome short of catastrophe is likely to be positive for the markets, at least over a period of a few months. This is simply because the resolution of uncertainty in and of itself gives investors a psychological boost. The Korean War and the bombing of Cambodia can't be construed as American victories in any conventional sense. Yet the Dow rose sharply both times following the immediate crisis. Certainly America has been fortunate to have prevailed in most of its military actions and to have avoided the dire consequences some predicted. While there's no guarantee that pattern will continue, there's no reason to assume now that the worst possible outcome is most likely.
Although the markets as a whole have generally rallied after the resolution of a military crisis, there seems to be no pattern to which industries or sectors fare the best. After the 1991 Gulf War, the year's top performers were biotechs, financials and small-cap growth stocks, but all were affected largely by economic factors unrelated to war. Financial stocks, for instance, benefited from lower interest rates. Significantly, two groups that fared the worst that year are traditionally seen as havens during war: energy and gold.
The long view is rewarded
To me, this supports something I have long maintained -- that long-term investing is a fundamentally optimistic endeavor. Throughout American history, despite war and recessions, the value of income-producing assets has tended to rise. Bears may have been right during recent years, but their timing has to be very good to make money long term. To be continuously bearish would be, for me, a recipe for financial disappointment, not to mention persistent crankiness. It may be prudent to use insurance to hedge against life's most serious risks, but it makes no sense for the long-term investor to build a strategy premised on the expectation of disaster. If it comes, our stock portfolios are likely the least of our worries.
By the same token, I feel squeamish suggesting that anyone seize upon war as a way to cash in on a market-buying opportunity. But I urge investors to resist panic selling and to take the long view. The American political and economic model has survived revolution, civil war, depression and countless other tribulations. Through it all, it has rewarded investors who stay the course.
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