Stocks and War

An academic paper looks at the war puzzle:

We study a number of large international military conflicts since World War II where we establish a news analysis as a proxy for the estimated likelihood that the conflict will result in a war. We find that in cases when there is a pre-war phase, an increase in the war likelihood tends to decrease stock prices, but the ultimate outbreak of a war increases them. In cases when a war starts as a surprise, the outbreak of a war decreases stock prices. We show that this paradox cannot be explained by uncertainty about investment decisions, nor by the expectation about a quick end of the war or ambiguity aversion. A connection of this puzzling phenomenon to mean-variance preferences of investors is suggested.

It doesn’t seem like much of a paradox to me. Investors get skittish during the run-up to war and then optimistic once the bombing starts. Why should we expect nationalist feelings to stop at the market’s edge?

War may be hell as Sherman said but it’s also what Heraclitus said — the father of us all. Ultimately, war focuses a society and by extension, the state. That resolution is a major boost to optimism and that spills over into stocks.

A perfect example of the sell-off during the run-up and buying spree once the war starts happened during the Iraq war more than eight years ago. Here’s how the S&P 500 performed in 2003 and 2004:

The market made a low in July of 2002, then tested it in October and in fact made a new low. Then it went back to retest it again in March of 2003. This time, the old low held and the market turned north and didn’t stop for four years.

We’ve also established a recent March pattern. The 2003 closing low came on March 11. In 2000, the closing high for the Nasdaq Composite came on March 10. Then in 2009, the S&P 500’s closing low came on March 9.

I’ve often noticed that investors always feel that they want to “wait and see what happens.” The thing is, they always feel this way — as if a resolved answer will be known to all in a matter of days. It doesn’t work that way.

I think that’s what causes the jitters during a run-up to war. Investors think that they ought to remain neutral and “see how this plays out.” When the war starts, it creates a buying storm as the market works to make up for lost ground.

(HT: CXO Advisory)

Posted by on June 8th, 2011 at 8:05 am

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