On October 9, 2006, news broke that North Korea had tested a nuclear bomb. After an early dip, the U.S. stock market ended the day with a modest rally. There's a growing sense of alarm that the war in Iraq is dragging on with no end in sight, and yet, the Dow Jones Industrial Average keeps hitting new highs. Is it that investors have become so saturated with bad news that they're tuning it all out?
Actually, according to analysts and academics, the recent behavior of investors in the U.S. stock market has been reasonably consistent with historical patterns. The consensus seems to be that short of a biochemical or nuclear attack on U.S. soil and given the right fundamentals--strong corporate earnings, relatively low interest rates and lower fuel prices--there is not much in the way of non-financial events that can throw the U.S. stock market seriously off course for very long.
"If it's a sudden shock out of the blue, the market almost always goes down. However, the market tends to bounce back--in many cases, quite quickly," says Ed Keon, Jr., the chief investment strategist and director of quantitative research at the Prudential Equity Group LLC in New York City.
A week after the World Trade Center bombing in 2001, Keon and his group started publishing reports on the impact of international conflicts on stock prices. They dubbed their reports the "Winds of War" series, borrowing the title of Herman Wouk's book.
One of their key findings was that "when the period of conflict is extended"--as it is right now in Iraq--"economic fundamentals tend to matter more than the conflict," Keon says. "Iraq is still not played out, and it's hard to say what the endgame will be."
Keon says the key question right now is whether the Federal Reserve can keep inflation in "the sweet spot"-- the 1 percent to 3 percent range-- "without killing the economy," and he believes it's likely that will "matter more than the backdrop of conflict."
Richard H. Earnest, a CFA and senior vice president of the HighMark Value Momentum Fund in Los Angeles, believes that the U.S. stock market is showing some signs of uncertainty and unease over the international situation or valuations would be higher. Historically, when inflation and bond rates have been "benign"--less than 3 percent and less than 5 percent--the market has traded at a range of roughly 16 to 19 times earnings, he says.
But in October, the level was "a little over 14 times earnings, and that was after a pretty significant rally, so that suggests to me that the market has been taking at least some of this into account," Earnest says.
One of the reasons the U.S. stock market is so resilient to shocks from overseas is its sheer size and dominance in the world, says Robert I. Webb, a professor of finance at the University of Virginia's McIntrie School of Commerce and author of the recently published Trading Catalysts: How Events Move Markets and Create Trading Opportunities.
As an example, Webb cites the Asian financial crisis of October 1997. The severe sell-off in Hong Kong had an impact on the U.S. market for just one day because, in context, the market capitalization of the entire market in Hong Kong was less than the market cap of General Electric, he says. Traditionally, major international political events like the ouster of Mikael Gorbachev in 1991 and the dissolution of the Soviet Union have caused immediate and sharp sell-offs in the markets in Frankfurt, Tokyo, Israel, and even London, while the market reaction in the U.S. was much less severe, he says.
"Location matters," he says. "Foreign events will usually have less of an impact [on the U.S. stock market] than domestic events," he says.
And the domestic event that seems to be in the back of everyone's mind for all of the obvious reasons is the possibility of another terrorist attack on U.S. soil.
"I think the one wild card in all of this is nuclear terrorism because the destructive power is so much greater and the impact lasts for a longer period of time," says Pat Dorsey, the director of stock analysis at Morningstar Inc. in Chicago. To poke a hole in the market's usual resiliency, "The event would have to be not only severe, but perceived as permanent and continuing to deteriorate over time," says Joseph H. Davis, an economist at the Vanguard Group in Valley Forge, Pa.
And it doesn't have to be a "mega-terror attack. It could be something "much more modest and much more harmful like suicide bombers in shopping malls" that could do real damage to the U.S. economy, says Yakov Amihud, a professor of finance at the Stern School of Business at New York University.
But, meanwhile, "you don't want to build that bomb shelter in your basement," and "your ability to plan for any non-financial event is next to impossible because you don't know what it will be or when it's going to strike," says Brett Gallagher, deputy chief investment officer at Julius Baer Holdings in New York City. Gallagher believes the best defense is simply a well-diversified portfolio. "It's one of the simplest tools, and it's not sexy," he says. "But you can't go defensive because you think Iran has a nuke and might create a war in the Middle East. If you really took to heart everything that could go wrong, you wouldn't have a very happy life," he says.
Rosalyn Retkwa is a New York-based freelance writer.
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