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War and Capital

09/17/01 01:18:06 PM
by David Penn

How do the capital markets react when the unthinkable strikes?

Security:   DJIA
Position:   N/A

In the wake of the terrorist attack on the United States on Tuesday, September 11, 2001, many market commentators have looked to history for some idea of how the capital markets -- the stock market in particular -- might react. Will the first assault on the mainland of the United States in over 100 years send already-weak markets reeling? Or will the much-spoken-of "patriotic rally" mean that investors will use this period of uncertainty to adjust their portfolios, dumping bad stocks under the cover of widespread, but short-term market declines, and loading up on quality names, now heavily discounted?

A number of previous crises have been resurrected -- the Cuban missile crisis, the Kennedy assassination and, perhaps more to the point, the Gulf War and World War II -- with the goal of comparing markets past to markets present. While this approach has its failings (no two crises strike a country or its people in the same way), looking at how the stock market fared during these previous episodes at least provides some sense of how markets CAN act -- and that knowledge alone may prove helpful in the uncertain days, weeks and even months to come.

The Nazi blitzkreig against Western Europe and the Japanese attack on Pearl Harbor both ignited major declines in the Dow Jones Industrials.
Graphic provided by: Prophet Finance.
The conventional wisdom is that crises induce selling at the outset, but once the magnitude of the crisis is digested and a response both planned and "sold" to the investing public, a rally will ensue. This thinking is most accurate in the war examples of the Gulf War and WWII. Even though the markets did rally from the declines that followed both the Kennedy assassination and the Cuban missile crisis, these rallies were relatively short-lived, as the predominant mood of the market (in the case of the Kennedy assassination and the Cuban missile crisis, that mood was of a secular bear) reasserted itself. On the other hand, both the Gulf War and WWII corrections came during secular bullish periods (1982-2000 and 1942-1962, respectively), which made their subsequent rallies seem, perhaps, all the more powerful.

Provided here is a chart of the Dow Jones Industrials from 1935-1945, with a few key events related to World War Two noted. Notice that while Germany's invasion of Poland seemed to have little effect on a chaotic market struggling toward the upside, the launching of the blitzkreig on Western Europe in April and May of 1940 did have a devastating effect, cleaving 24% out of the market in a matter of weeks. The markets struggled to recover as Hitler consolidated his hold on continental Europe, but were again battered by the news of the Japanese attack on Pearl Harbor in December 1941. The market decline from this shock was equally severe, as the Dow lost 28% before finally bottoming in the spring of 1942.

It is true that the Dow rallied strongly from that point, and was sitting at 145, where the Dow was on the eve of the blitzkreig in Europe, in a little over a year after reaching a bottom. But it would take the Dow fully six years to return to the level it was before the Nazi invasion of Poland. This underscores the notion that, while stocks have a tendency to rally after steep, national crisis-types of emergencies, the declines they do experience are very real. And until some sort of response to the crisis becomes clear (call it "crisis visibility" if you will), the markets are liable to remain defensive.

It is also worth remembering that direct action on the markets almost always has greater consequence than indirect action. Compared to the sell off in the spring of 1962 when President Kennedy took on the steel industry, the declines during both the Cuban missile crisis and the Kennedy assassination were relatively small. Similarly, the sell-off in the fall of 1987 (brought on by a host of offenders -- from the "failures" program trading and portfolio insurance to Treasury Secretary Baker's fight with West German interest rates) was sharper than the decline that accompanied the Iraqi invasion of Kuwait in 1990 (a 36% drop in the Dow in 1987, 20% drop in 1990).

Ironically enough, 1942 -- the year the market bottomed -- was characterized by a series of Allied defeats in the Pacific Theatre, most familiarly at Bataan and Manila Bay, as well as the massive internment of Japanese-Americans living on the Pacific coast. This seems to contribute toward the idea that bottoms often come at times when the outlook -- political, military and economic -- is perhaps at its bleakest.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine,, and Advantage.

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