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What War Means for your Wealth
Talk of war has understandably unnerved investors and markets around the world. The reason is not hard to find — investors hate uncertainty and instability. On average, a war or crisis event has resulted in a 7.8% decline in the US stock market and a 7.1% decline in the Canadian stock market. This article outlines how investment markets have experienced, survived and eventually gone on to recover from numerous wars and historical "crisis events" — but warns it is wrong to assume that the market will automatically follow the pattern and rally once war begins.
Don't invest based on worst-case scenarios
Investors should avoid reacting to what some are outlining as worst-case scenarios. Such scenarios suggest that the war will push energy prices to all-time highs, eroding company profits, further stunting hopes for a global economic recovery, and sending stocks to decades-long lows.
After all, simply because it is a worst-case scenario means it has as much chance of occurring as, say, the best-case scenario. Investing on the basis of such a scenario — either worst-case or best-case — is highly risky.
The Fear of Uncertainty
The uncertainty, fear and prospect of war often have unnerved investors more than the war itself.
A recent example was the Iraqi invasion of Kuwait in late months of 1990. US stocks (as measured by the S&P 500) fell almost 13%; Canadian stocks (S&P/TSX Composite Index) fell almost 5% as investors became concerned about the impact of the invasion on financial markets around the world.
When the Gulf War began in 1991, however, stock markets rallied. By 250 trading days after the market bottom, US stocks had risen 24% in value. The uncertainty was removed and investors believed that the allied forces would prevail.
Another example is the Japanese attack on Pearl Harbor on December 7, 1941 during World War II, which plunged the markets into fear and uncertainty. But with the American victory at Midway in June, 1942, US stocks rallied as investors anticipated an outcome to the war favourable to the United States and its allies.
With the onset of the Korean War in June 1950, investor uncertainty saw the US stock market shed 13% of its value in a three week period prior to the Battle of Osan (the first allied ground action in the conflict). Sixty five trading days later the market had rebounded over 18%; 125 trading days later the market had experienced a gain of 28% — as the position of US involvement became clearer to investors.
History suggests that the onset of war could only have positive implications for the stock market, if only because it removes the uncertainty that the current situation involves. Markets are efficient in that they price in all currently available information: that is, the possible adverse economic circumstances which may flow from a war are already factored fully into the price.
Historical Reactions
While history is no prediction of the future, it is useful to reflect on the response and recovery of the stock market in similar times of pressure and uncertainty throughout the past sixty five years.
History has shown us that a dramatic downturn has been followed by prolonged periods of growth exceeding the point where the drop in values occurred.
A crisis, on average, will see the US stock market fall by 7.8%. Twenty-five trading days later, the US market recovers over half of its losses. By sixty five trading days post-crisis, the market only is fractionally behind its pre-crisis point — and by 125 and 250 trading days following the crisis, that market has, on historical average, gained 14.3% and 19.1% from the crisis low point. In only three out of 26 crises had the market not recovered from its low-point 250 trading days following the initial market reaction.
Historically, the Canadian stock market has reacted similarly to war/crisis events as its US counterpart, experiencing slightly smoother reactions and recoveries.
It is important to note that any analysis of this sort contains a subjective element. One might debate the reaction dates chosen by which the market 'reacts' to news and information. While it is clear that not every war/crisis event results in a sharp stock market drop, a general pattern does present itself.
Initially, there is a 'flight to safety' — investors heavily sell off assets with the highest levels of risk — such as small-caps and stocks from overseas markets, moving into more defensive (lower risk) asset classes such as cash and bonds. This is a short term reaction, lasting anywhere between one day and several months. This is often followed by a period of uncertainty and volatility at the bottom, whereafter the market tends to recover with strong gains after 125 trading days.
This historical pattern reflects a stock market overreaction caused by uncertainty — and is in essence a reflection of the rising risk premium of investing in stock. An equally strong recovery rebound occurs once the degree of uncertainty reduces, and it becomes apparent that the long-term implications of the war/crisis for the economy have been minimal.
Latest available figures suggest that geopolitical uncertainty has hit the Canadian stock market — with the S&P/TSX Composite Index finishing down 0.5% for the month of January and 12.5% for the 12 months to the end of January 2003.
* All figures are averages of the 26 events referenced
History Doesn't Always Repeat
While the tension and anxieties of war are difficult for most investors, a victorious outcome is among the best news that a stock market can receive. The end to World War I culminated in the roaring 20's. The conclusion to World War II saw a bull market that did not downturn until 1966. And the resolution to the Cold War and the Gulf War were followed by the strong double-digit returns of the 1990's.
That's not to say, however, that the markets will react the same way this time. Although investors face uncertainty now and are unnerved by the possibility of war, it does not necessarily follow that the uncertainty will be lifted should war begin. For example, indications that the US and its supporters might get bogged down in a protracted war may produce even more uncertainty.
Even signs of a swift end to the war might not remove the uncertainty. The possibility of further terrorist attacks on US or European soil is a wild card which may serve to further extend any instability. And if oil prices continue to rise, investors could succumb to fears of a double-dip recession in the United States, introducing the added element of economic uncertainty and its repercussions for the rest of the world.
Other factors also make it difficult to determine the future direction of any movements in stock prices.
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- There is no example in recent history when the bursting of a stock market bubble has so closely preceded the outbreak of war.
- Uncertainty has seen investors move assets out of global stock markets and US currency and into 'safe haven' assets oil, gold, treasury notes and Euro currency. In the event of a decisive and favourable outcome to the conflict, and a stock market rally, assets that benefited from the anticipation of war might face a sharp reversal.
- Price to earnings valuations have roughly halved from their bull-run highs, with the S&P 500 stock index now trading at about 16 times expected earnings this year; the UK market 18 times and Canada 14 times.
- Globalization, advancements in information technology and the 'CNN Effect' have empowered individual investors with an abundance of information. They have made the impact of market-jarring crises more quick and more widely felt around the news. They have also allowed the market to 'price-in' risk premiums ahead of time. However, the media and other sources tend to overstate and sensationalize news. This results in added uncertainty and emotions for investors.
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What, then, should investors do?
Short-term investors may be better protected by more conservative portfolios in the next few months - but then they should already have adjusted their investments according to their goals, and likely need to make few changes.
Long-term investors should avoid overreacting to the uncertainty today. In five years, they could look back on the events of this year and realize that by moving into more conservative investments they missed out on strong gains.
Trying to anticipate events of the next few months remains little more than guess work. Using guesswork to determine investment decisions never is a good idea. The best thing that long-term investors can do is to stick to their asset allocations, to ride out any sharp downturns in equities, and to be positioned for any strong gains that may occur.
This is a publication of Russell Investments Canada Limited. The information and any statistical data herein have been obtained from sources which we believe to be reliable but we do not represent they are accurate or complete and they should not be relied upon as such. All opinions expressed and data provided herein are subject to change without notice.
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