The impending war raises disparate emotions within us. The older
members of society know the economic, as well as psychological,
ravages of war, especially when the cause is far from idealistic
and the location is an alien land. The members of society who are
students or part of the working class are concerned about the
impact a war could have on the economy. What’s more, none of
us like the idea of deliberately committing American citizens to
warfare and possible death. Our support or lack thereof for the war
emanates from our views about the Iraqi regime and beliefs about
its possible links to terrorism. Furthermore, those same views
regarding war will no doubt affect investments and the stock
market.
Optimism fuels investment in risky assets like stocks. During
wartime, when American citizens are engaged in combat, and we
receive daily reports of past and imminent casualties, optimism is
impeded. This is likely to cause depressed investment in stocks.
Such a phenomenon has direct and indirect consequences on stock
valuations. The direct impact is this lack of buying pressure
attenuates upward movements in stocks. The indirect impact is that
lack of trading activity reduces liquidity in the stock market,
which causes stocks to become less valuable to investors. Even if a
war has no direct impact on the economy, people will tend to have
less of an optimistic outlook than in normal times, which in turn,
will affect stock market levels.
A related issue is that of overreaction to catastrophic events.
Research has shown that stocks tend to rebound after extreme drops
of more than 10 percent on a given day. This points to overreaction
in the short term. Evidence as well as reasoning suggest that when
war is declared, the market will initially tend to plunge and then
partially recover over a period of a week or so. Thereafter, the
general lack of optimism will take over, and the market will tend
to lack upward momentum. Still, there is a way to prevent
investors’ frenzy.
We, as investors, should avoid emotions from taking their toll
on our investments by carefully assessing the consequences of
trading before taking impulsive actions to liquidate them as soon
as war is declared. We should rationally consider the economic
consequences of war before reacting by trading in response to such
an event.
On the face of it, the direct consequences of a war appear
limited. Iraq in no way controls oil supplies, and the United
Nations’ sanctions have limited the extent to which it can be
a dominant player on the world market. Except for the unlikely
possibility of Iraq taking foolhardy actions, such as committing
veritable suicide by bombing Kuwaiti oil fields, we should expect
little impact of the war on oil supplies. Of course, the impact on
oil prices is another matter. These prices are governed by
sentimental as well as rational considerations. If consumers become
willing to accept a greater oil price in the mistaken perception
that oil supplies are drying up, then producers will be only too
happy to raise prices. This appears to be a major factor driving
gas price increases over the past few days. While individual
citizens have little control on the aggregate public perceptions,
we can do our bit by cutting back demand at unreasonably high
prices and by going to low-price gas outlets or switching to lower
octane gasoline.
A possible impact of war that makes economic sense is that
government budgets can temporarily be thrown into disarray by
increased military expenditures, which could impact taxes as well
as interest rates in the economy. However, the U.S. economy is so
productive and rich, and the Federal Reserve Board (which sets
interest rates) is so brilliantly competent that it is not clear
whether this will significantly impact the corporate sector. The
blue-chip firms as well as the biggest technology companies that
fuel much of our economic growth should be affected little by the
possible impact of war on the economy.
In conclusion, there appears to be differing opinions of war in
our society. My personal opinion is that in the face of available
evidence, it is foolhardy to go to war. The only piece of evidence
that would be compelling justification of war is conclusive links
of Saddam Hussein with Al-Qaeda. If such proof is absent, it makes
little sense to go after Hussein.
But regardless of our opinions, war will move the stock market.
It appears that the more serious implications arise from a lack of
“investing optimism”, as opposed to rational
considerations. The more we suppress emotional reactions to such an
event, and the less willing we are to be emotionally manipulated by
producers of essential commodities such as oil, the better we can
cushion the economic impact of the war.
Subrahmanyam is a professor of finance at The Anderson School
and a co-editor of the Journal of Financial Markets.