Pricing Armed Conflict

International military conflicts and terrorism can sometimes have a big impact on stocks. But probably not exactly in the way you'd think.

International military conflicts and terrorism can sometimes have a big impact on stocks. But probably not exactly in the way you'd think. Here's a primer.

The Economics of War

Various estimates of the cost of the Iraq war are always headline-makers.

Cost of Iraq War Could Surpass $1 Trillion
By Martin Wolk, MSNBC

All kinds of numbers are bandied about when thinking about current US war efforts. The implication of stories like these is, "Look how much this is costing! Our economy can't take it!" The best numbers we've seen indicate the cost of the Iraq war is in the neighborhood of a little over $80 billion a year.

Is that a lot or a little? To be clear, this is no political statement. Whether you're for or against the war, the point is to see that it really doesn't cost much. $80 billion a year is not even a percent of US GDP. Not even a percent!

Some say the costs of war are killing the economy, others say wars stimulate the economy. We say—it probably isn't doing much of either. This war is actually a pretty small thing economically. Thus, judging the actual cost of a war needs to be put into proper scale. $82 billion a year for war would probably cripple Croatia's economy, but it's peanuts for the US.

All About Anticipation…

Something folks commonly believe is the outbreak of war will cause stocks to drop. Well, that's almost exactly wrong. It's the anticipation of conflict, not the conflict itself, which generally puts pressure on stocks.

If you go back through history, it's the period leading up to war that holds stocks down. Once conflict starts, stocks tend to rebound. Both Iraq wars (1991 and 2003) shared this feature. It was even true for US stocks and World War II.

Of course, this isn't true 100% of the time and there are exceptions, but it's accurate pretty often. Risk aversion tends to be highest leading up to war because investors don't know for sure if the event will happen or not. Once a conflict starts with certainty, that particular unknown is taken off the table and thus stocks are freer to move upward. This is true especially when the outcome of the war is virtually certain, like the US/Iraq conflicts. Once they started, there was little doubt who'd win. That's an easy thing for stocks to price.

The Surprise Factor

Recent news of Turkish troops amassed at the Iraqi border is not particularly disconcerting for stocks. The threat represents a new risk in the Middle East, namely that a conflict involving the Kurds could erupt across Turkish, Iraqi, and Iranian borders.

Kurdistan Showdown
By Ilan Berman, The Wall Street Journal (*site requires registration)

Turkish PM refuses to rule out Iraq invasion
Suna Erdem, The Times Online

Iraqi FM: Turkey Massing 140,000 Troops
By Bushra Juhi, The Associated Press via ABC News

At this point it seems highly unlikely the conflict would drastically disrupt the global economy—should hostilities break out at all."

But it's not the conflict itself we want to focus on right now. This potential event is more or less under the radar—not a lot of people are talking about it, and few are taking it seriously. It's a back page story on almost any newspaper. Maybe folks are right to generally ignore it, maybe not. The point is, should a large scale conflict involving a big chunk of the Middle East commence tomorrow, it would take quite a few people by surprise.

Surprise is bad for stocks. We like our geopolitical events to be anticipated and therefore fully priced into markets before they happen. When big events take us by surprise, they can pull stocks down pretty quickly in the short term.

That's the big risk with terrorism. Terrorism is a perpetual threat—a bearish harbinger always hanging over stocks and the global economy. It's completely unpredictable and always will be, and thus always a danger to stocks.

But the thing about terrorism is it's never seemed to have a big long-term impact on markets. Even the biggest, most successful terror plots haven't done much to batter stocks. September 11, 2001, the largest terrorist attack in world history, sent stock markets worldwide reeling. But…just a few months afterward markets fully recovered and hit pre-attack levels.

That's the power of surprise. No one knew what to make of 9/11 when it happened. But once the dust settled and markets were able to weigh the economic impact, stocks recovered. This, of course, is to take nothing at all from the tragedy itself, but only to point out the effect was more psychological than it was economic.

New threats such as Al Qaeda's "response" to Salmon Rushdie's impending knighthood are risks—who knows what terrorists will do, or the magnitude of their actions? One thing we can say is, as subsequent terrorist attacks since 9/11 occurred, markets have done an excellent job of pricing them quickly. Attacks in the UK and Spain in recent years (including the attack on the UK's Glasgow airport earlier in 2007) barely moved stocks for even a day.

Al-Qaeda Threatens 'Response' to Rushdie Knighthood
By Staff, TurkishPress.com

Today's risks are really no more than any other time. Geopolitical conflict and terrorism are always a possibility, and that's an inherent part of the basic risks of investing. But there are ways to navigate it. Use history and financial theory as your guide, and work to separate the economic impact from the psychological impact.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.