Terrorists Attack Already Priced Into Market

by | Jun 4, 2004

This column is going to be about what no investor wants to talk about: another terrorist strike on American soil, and how could it affect the stock market. How likely it is to happen — and when? “When” is really the only question. Not “if.” Who knows how many attempted attacks have already been thwarted, […]

This column is going to be about what no investor wants to talk about: another terrorist strike on American soil, and how could it affect the stock market.

How likely it is to happen — and when?

“When” is really the only question. Not “if.” Who knows how many attempted attacks have already been thwarted, and not publicized? Someday there will be one that doesn’t get stopped.

There already has been. And not just one. September11, 2001, was the second attack on the World Trade Center towers by Islamic extremists. The first was in 1993, when a truck bomb was exploded in an underground parking area. Causing only six deaths, it received relatively little public attention at the time. But believe me, if there’s a repeat performance at the Sears Tower in Chicago, it would grip the nation in fear.

And how about the truck-bomb that demolished the federal building in Oklahoma City in 1995, with 168 people dead? No one called it “terrorism” at the time — but if it happened today, they sure would. The fact that it wasn’t the work of Islamic extremists might even make it worse if it happened today: It’s some comfort now to think that all of our threats are in one narrow category.

With the presidential election coming up, there’s some reason to think that there could be an attack this year. After all, al Qaeda claimed credit for the Madrid train bombing that occurred days before Spain’s presidential elections three months ago.

From Cox and Forkum

An election connection is affirmed by the prices of terrorism futures contracts that trade online at Tradesports.com. The contracts allow traders to bet on the Department of Homeland Security’s color-coded alert status at the end of each month — so we can actually determine the market’s best estimate of what will happen and when.

Sounds crazy — and a little grisly — but here’s how it works. For each coming month, there’s one futures contract for each alert color. The contract on whichever alert color is in force at the end of the month pays off at a value of 100, while all the others expire at zero — worthless. So each contract price today indicates the probability that a particular alert color will be the winning one.

The alert level today is yellow — which means “Elevated.” Most of Tradesports.com’s contract for the rest of the year put an 80% or greater probability that today’s yellow alert status will remain unchanged. But in October, just before the election, yellow’s probability is only 50%. For October, orange — which means “High ” — is almost as likely at about 45%. There’s even a 5% probability of red, which means “Severe.” The chart at right shows what all the futures contracts are predicting for the rest of the year.

So how would the stock market react if there really were an attack in October? If we assume that it would be no worse than the September11, 2001, attacks in terms of loss of life and disruption of national infrastructure (in other words, let’s rule out a nightmare possibility like the detonation of a nuclear bomb in Washington, D.C.), then we already have a worst-case scenario to work from: the September11 attacks themselves.

Why was that the worst case? Primarily because those attacks came as a complete surprise in every sense. With no risk premium already built into prices, stocks had to drop to reflect the full economic impact of the attacks. Moreover, government and industry had to start from scratch to adapt to a new world in which such events were suddenly possible. Such adaptations are costly — especially when you are making them for the first time and are likely to make mistakes along the way.

Another worst-case element of the September11 attacks was that they physically affected two important components of America’s economic infrastructure — our airlines, and our capital markets.

Yet for all that, the day the markets reopened after the September11 attack, the S&P 500 was down only 4.3%. At the very worst, four days later, the market traded as much as 13.0% lower. But that turned out to be a great buying opportunity. Just a month after the attack, the market had entirely recovered to its pre-attack level.

Today, though, the S&P 500 is only 2.1% higher than where it closed on September10, 2001 — when the World Trade Center towers were still standing. How can that be, when since that time the economy has recovered from recession, gross domestic product has grown more than 10% and S&P 500 forecasted earnings have grown almost 28%?

It’s all a question of valuation. By September 2001 the bloom was already off the bubble market of 1999-2000, but equities were still overvalued according to my model. Today they are undervalued — to almost precisely the same degree they were overvalued the day before the September11 attacks. Surely some of today’s undervaluation is a premium exacted in anticipation of another attack — somewhere, someday.

That suggests to me that when that attack finally comes the market’s reaction may be less negative than it was on September11, 2001 — provided that the attack is of no greater magnitude.

But the reaction will still be negative. Even an event that is fully expected can cause some negative reaction, simply because its exact timing and probability were previously unknown. And there’s also the fact that there are plenty of people who are in denial about the possibility of another attack. That’s consistently shown in public opinion polls, in which voters rank terrorism among their least urgent concerns. When the next attack comes, those people will get a rude awakening. Markets will trade lower at first to accommodate their panic.

My best guess is that once the panic has burned itself out, markets will recover and trade higher — just as they did shortly after the September11, 2001, attacks. Does that imply that, in some grisly way, a terrorist attack could actually be good?

Perhaps so — as horrible as that is to say. For all that would be lost in another attack, something would be gained, too. And I’m not just talking about a trading opportunity. It’s something we need very much right now: a sense of national coherency.

In the fool’s paradise of being free of attacks for almost three years, America’s political life has degenerated into hateful partisan warfare. Extreme national disharmony creates an environment of instability that is devastating to economic growth. Whoever wins the presidency next November, I shudder to think of the next four years following an election as bitter as this one is sure to be. A terrorist attack would, if nothing else, unite America — whether behind President Bush, or behind President Kerry.

Here, then, is my bottom line on this most gruesome — yet critical! — investment decision. Don’t be afraid to hold stocks just because you know there will be another attack — a lot of the risk is already priced in. And when there is another attack, buy the market. Once again, it will be as Baron Rothschild said centuries ago: The time to buy stocks is when there is blood in the streets.

The above is an “Ahead of the Curve” column published June 4, 2004 on SmartMoney.com, where Luskin is a Contributing Editor.

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

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