A Deeper Look at Markets and Conflict
Investors often grapple with contradictory beliefs regarding the impact of war on their portfolios. On one hand, there's the notion that "war is good for the economy," while on the other, markets are seen retreating in anticipation of conflict. Many look to past conflicts, like the Gulf War, expecting market declines before the onset of hostilities, followed by a rebound once the dust settles. If this is the typical market response to war, the current prewar environment could present investment opportunities. However, this bullish sentiment might simply reflect the "availability heuristic"—a cognitive bias where decisions are based on recent, readily available data, as described by Amos Tversky and Daniel Kahneman.
But how do markets really respond to international conflicts, and what could this mean for today’s investors? In this article, we'll explore the psychological research on stress and uncertainty to suggest that the relationship between stock market performance and wartime events hinges on the level of uncertainty. As a barometer of a nation’s economic value, markets tend to discount uncertain or unfavorable war outcomes, while rewarding nations that appear poised for success. A closer examination of market behavior during recent wars reveals a significant correlation between the outcomes of conflicts and market trajectories—insights that are crucial for understanding how to navigate your portfolio during times of war.
Stress, Uncertainty, and Market Behavior
Research shows a curvilinear relationship between the likelihood of negative outcomes and emotional stress. When the probability of a negative event, such as an electric shock, is near zero, people feel secure, exhibiting minimal stress responses. At the opposite extreme, when the probability is close to 100%, individuals often engage in coping strategies, managing their stress effectively. The highest stress levels occur when the probability hovers around 50%, creating uncertainty. Faced with this ambiguity, stress responses, such as elevated heart rate and stress-related hormone release, are at their peak.
Applying this research to market dynamics leads to what might be termed the "Fortunes of War Hypothesis": As a nation’s success in conflict becomes more apparent, investors gain confidence, leading to market rallies. Conversely, when war outcomes are uncertain or unfavorable, markets tend to retreat. Historical data supports this hypothesis, showing a clear link between war outcomes and market performance.
Markets and the Fortunes of War: A Historical Perspective
World War II provides a striking example of how market outcomes are tied to the fortunes of war. According to research by Elroy Dimson, Paul Marsh, and Mike Staunton (in "Triumph of the Optimists"), the stock, bond, and bill markets of the U.S., U.K., and Switzerland significantly outperformed those of Germany, Italy, and Japan during the 1940s. The winners’ markets showed positive real returns, while the losers’ markets suffered negative returns, exacerbated by currency depreciation.
Even before the U.S. officially entered World War II, the Dow Jones Industrial Average was reacting to war developments. For instance, when Germany launched its Western Europe offensive in May 1940, the Dow dropped approximately 25% in two months. The market’s fortunes only began to turn with the U.S. victories in the Pacific and North Africa in 1942, echoing Winston Churchill’s observation: “Before Alamein we never had a victory. After Alamein we never had a defeat.” The Dow followed suit, rising from a low of 92.92 in April 1942 to 165.44 by April 1945.
Later Wars and Market Correlations
Similar patterns can be observed in subsequent conflicts. The Korean War saw a 10% drop in the Dow during the initial North Korean offensive, followed by a recovery as U.S. forces gained the upper hand. The Vietnam War, however, paints a different picture. The Tet Offensive in 1968, while a military success, eroded public support for the war, leading to a 10% drop in the Dow. The prolonged nature of the conflict, coupled with rising interest rates and inflation, further dragged the market down by over 50% in real terms by the war’s end.
In contrast, the Gulf War in 1990-1991 was brief and decisive. The Dow hit its bottom before the U.S. military intervention, and as the campaign’s success became apparent, the market surged, gaining over 15% by the war’s end.
Implications for Today’s Investors
The early stages of war, marked by uncertainty, have historically brought market declines. Only when a conflict’s outcome becomes clear and favorable do markets tend to recover. In the context of modern conflicts, such as the Iraq War or broader anti-terrorism efforts, this pattern suggests that investors should carefully consider what constitutes "victory." The complexity of contemporary warfare, with its ambiguous battle lines and the ongoing threat of terrorism, makes predicting market reactions more challenging.
For example, while a swift regime change in Iraq might initially boost markets, the broader war on terrorism complicates matters. A rapid victory could buoy investor confidence, but unless such victories lead to a broader reduction in uncertainty—such as a decisive blow against terrorism—market gains may be limited.
In conclusion, while war’s impact on markets is significant, it’s the uncertainty of outcomes that drives investor behavior. By understanding this dynamic, investors can better navigate their portfolios through times of conflict, recognizing that the most critical factor may not be the war itself, but the degree of certainty surrounding its outcome.
