Has the market priced in the threat of terrorism?
June 3, 2004 (updated 6/5/04)
This is the awful question that no one really wants to ask, but any prudent investor must at least give some passing thought. What brought this question back into my mind is hearing and reading several references claim that the price of oil carries up to a $10 terrorism premium. That means if the terrorists were suddenly to come to their collective senses, the price of oil could drop upwards of 25%. Wow, 25%?!? How did the market come up with THAT much of a cushion? A Saudi official recently reminded the world that despite all the recent attacks by terrorists that not one barrel of oil of production has been lost. Indeed, oil is such an obvious target that governments have had a HUGE interest in hardening those targets pretty thoroughly. Just look at how much energy the US put into protecting Iraqi oil fields as it marched through the sands on the way to Baghdad. Does the oil market know something we don't? Or is the oil market just particularly vulnerable to fear and speculation? Probably a little of both.
So of course, one cannot help but wonder could the stock market be a lot HIGHER if it were not for the on-going terrorist threat? I believe one quick look at the chart would suggest to that the market is pretty much ignoring most, if not all, possibility of a significant terrorist threat. Not only has the market been exceptionally strong, but the VIX, the favorite measure of volatility and fear in the stock market, is at historic lows. Obviously, the market will only price in a terrorist threat if it has to (and let us pray it never has to!). Does the market know something we don't? Or is the stock market particularly smug and full of its own self-importance? Probably a little of both!
The real point is that global economies have been so strong that the stock market could not help but charge forward against all headwinds. The potential threat of terrorism is a huge unknown quantity. Any attempt to assess the potential harm of such a tragedy on global economic output is near futile given the scale and scope of what could happen. But just as a thought experiment, let us say that the stock market should be taking a cue from the oil markets and price in a 25% fear premium. You even might be tempted to consider 33% to be the proper premium - 33% comes from dividing the $10 terror premium by the $30 price oil would be without terrorism. Regardless, let us further assume that the market currently could not care less about the threat and is fairly valued. This would mean that the Dow should be at 7646 and the S&P should be at 837. This kind of haircut would essentially wipe out the bear rally gains that began in March of last year. It would take a steeper cut in the Nazz of, you guessed it, 33%, to return to those nauseating March lows. Adding to this intrigue of numerological proportions is that the S&P has recently stalled out at the post 9/11 rally high around 1170 (the Nasdaq and the Dow just barely got over their post 9/11 highs before turning around).
Pure coincidence? Probably? But consider that at those March lows fear was heavy over the consequences of war. These fears briefly outweighed the hope and promise of a coming economic mini-boom. Now that we have had the boom, and the boom looks to be peaking, the door is open for fear again (or at a minimum the door is open to use this fear as a convenient excuse or explanation for the market's weaknesses). I would be hard-pressed like other bears to claim that the market will retest those lows of yesteryear, but I think any prudent investor should carefully consider what assumptions must be proven true to keep the market afloat and what factors might be holding the market back. I contend that fear of terrorism is NOT a major factor right now --- in fact, perhaps some of you might conclude that the better question to ask is whether the market should even bother pricing in the threat of terrorism in the first place!
Yet, I find this quasi-complacency ironic given that the oil markets are so ready to price in a fear of damage to well-protected targets while the stock market gives little more than a passing thought to the vast array of vulnerabilities in the rest of the global economy. Sure the oil market is naturally more volatile and more fluid and is more subject to the pressures of fear and greed than even the stock market. And sure world economic output suffered little after such recent tragedies like the Madrid train bombings. And again, the potential damage of the terrorist threat is hard to even fathom. But these terrorists are clearly trying to destabilize the global economy as the fastest way to foster chaos, despair, and the rule of lawlessness - oil is a convenient focus for now as it is closest to them. Is it then proper to essentially neglect the threat? Let us pray that the market is correct in its confidence, but let us not blithely assume that it is correct either. Back in early 2001, I wrote about the "boiling frog," and I later trembled to think that 9/11 could have been that boiling cauldron. Don't worry, I am not having any more of those feelings of foreboding (I am a much more optimistic person now, honestly!!!), but nonetheless, as I always say, be careful out there! After all, even the markets have their limits in fortune-telling!