“War is Hell”

In answer to the pleas of the citizens of Atlanta trying to save their city from destruction by fire, General Tecumseh Sherman wrote his infamous response “war is hell.”  As May draws to a close, it is war that worries equity markets.  Continued improvement of the economy has been insufficient to lift stock prices.  The declining dollar, Israeli-Palestinian tensions, and looming war between nuclear powers, India and Pakistan continue to suppress equity values.  It seems like that old malaise is back.

The dollar is not really in bad shape, but even small declines these days often create irrational fears among investors.  As Lawrence Lindsey, head of the White House National Economic Council, pointed out yesterday, the dollar is only off a bit from a lofty level.  “From its bottom in 1995, on a trade-weighted basis, the real dollar exchange rate was up 33%” to its peak earlier this year.  The recent decline puts the dollar off 3% from that peak.  “You know, off 3% is like a wiggle on a 33% trend line,” he said.

One fear is that a weak dollar will cause foreign investors to rethink their U.S. stock and bond holdings.  No such exodus of foreign money has yet occurred, but the fear has served to keep the Dow Jones and S&P 500 averages down.

Another factor blamed for keeping stock prices down in the last several months has been terror.  We are learning as a country what it is to deal with the constant threat of terror at home.  Israel has understood this threat for many years and it can be demonstrated in its stock market.

David Simons, of Forbes magazine, prepared an admittedly cold (his description), but informative comparison of Israel’s market performance and ours in the wake of 9/11.  He points out that In Israel’s continuous terrorism has killed 300 civilians over the past 12 months.  As a percentage of population, that’s equivalent to 13,000 in the U.S., or five World Trade Center attacks.  Yet the Tel Aviv 100 stock index, which fell 8% after 9/11, beat its U.S. counterpart, the S&P 500, throughout the past year, falling 11%, versus the S&P 500’s 15% decline.

Simons goes on to suggest that “Israel’s extreme experience may also suggest limits on how much of the U.S. market’s malaise can be attributed to the threat of terrorism.  The Israeli government and private economists estimate that two-thirds of the savage tumble in Israel’s GDP growth, from 6.4% in 2000 to a current rate of zero, was due not to terrorism but to the worldwide slump led by high-tech.  Indeed, excluding the intifada meltdown, the Tel Aviv 100 fell no more than did the S&P 500.  In the boom years 1999 and 2000, Israel’s 4,000-company tech industry accounted for 15% of GDP, nearly double the U.S. percentage.  Most of the revenue came from outside Israel, especially America. Exports by Intel‘s Israeli operation alone were 2% of year 2000 GDP.  Though the tech debacle hit Israel harder than it did the U.S., short of nuclear attack, stateside stock markets will weigh the traditional economy at least as heavily.  Though increased defense spending raises the risk of a budget deficit, much of the money ends up in the private sector.  Still, it may be optimistic to think that U.S. stocks can adequately anticipate terrorism. Israel’s market has far more experience assaying the cost. Let’s hope U.S. investors won’t need to gain that level of expertise.”

Our latest “war” prior to the ‘war on terrorism’ was in August of 1990 when Saddam Hussein and Iraq invaded bordering Kuwait.

S&P 500, June 1988 through July 1992

As you can see, the market fell off precipitously (20%) in the days and weeks following the invasion, but recovered just as quickly in mid-January of 1991 once it was apparent to investors that US and allied forces would decisively turn back the Iraqi invasion.  By March of 1991 the index had resumed its upward slope.  Concurrent with the war was a recession; so like today, it is impossible to isolate a single cause for market malaise.

Finally, the India and Pakistani conflict offers up a new set of unknowns.  Secretary of Defense, Donald Rumsfeld heads to the region next week in an attempt to diffuse the conflict.  President Bush has been unusually blunt in his calls on Pakistani President Pervez Musharraf to prevent Muslim militants from conducting terrorist attacks in Indian-controlled Kashmir.  No one knows where the conflict will end, but many world leaders are placing pressure on both sides to end it without war.  The performance of global markets will continue to be impacted until some resolution to the conflict is fond.

Finally, the economy continues to show signs of recovery.  Consumer confidence continues to creep up while the rate of job loss declines.  The Labor Department released May’s Consumer Confidence number on Tuesday with a reading of 109.8, close to expectations and an improvement over April.  The University of Michigan Confidence indicator, released today, came in at 96.9, slightly better than expected.

The great news today is that factory production continues to increase.  Both the Chicago Purchasing Manager index and Factory Orders came in well above expectations as you can see in the chart below.  They continue to press the case that recovery continues and the fuel that drives stock prices higher is on the way.

May, while not a banner month for investors, was considerably better than April.  The economy is doing its part to strengthen equities markets.  As investors learn to discount the new threats of terror and potential war in the Kashmir region, we should see some moderation of market volatility and improvement in stock prices.