is shown in Figure 13-1.
221Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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FIGURE
13–1
S&P 500 Futures Market on Tuesday Morning, September 11, 2001
The news of the plane crash spread quickly, but few imagined whathad really happened. Was it a large or small plane? Was it an accident? Orwas there something more sinister going on? Although nobody knew theanswers yet, immediately the stock index futures market traded down afew points, as it often does when uncertainty increases. Within a few minutes, however, buyers reappeared and the index returned to its previouslevel, as most traders concluded that nothing significant had happened.Fifteen minutes later, at 9:03, with news cameras focused on theWorld Trade Center and millions around the world watching, a secondplane crashed into the Towers. The entire world changed in that moment. Americans’ worst fears had been realized. This was a terrorist attack. For the first time since World War II, America was under directattack on its own soil.By 9:05, two minutes after the second crash, the S&P futuresplunged 30 points, about 3 percent, indicating that if the exchanges had
CHAPTER 13 When World Events Impact Financial Markets
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been open, nearly $300 billion would have been wiped off of U.S. stockvalues. But then, miraculously, buyers did appear. Despite the enormityof the events unfolding, some traders bet that the market overreacted tothese attacks and decided that this was a good time to buy stocks. Thefutures firmed and ended the session at 9:15 down about 15 points, gaining back one-half of the earlier loss.Despite this comeback, the gravity of this attack quickly sunk in.All the stock, bond, and commodity exchanges first delayed openingand then canceled trading for the day. In fact, stock exchanges in theUnited States would remain closed for the remainder of the week, thelongest closing since FDR declared a “Bank Holiday” in March 1933 totry to restore America’s collapsing banking system.Foreign stock exchanges, however, remained open. It was 2 p.m. inLondon and 3 p.m. in Europe when the planes struck. The German DAXindex immediately fell over 9 percent and ended the session around thatlevel. London stocks suffered but not as much. There was a feeling thatwith the world’s financial center, the United States, vulnerable to attack,some business might move to the United Kingdom. The British poundrallied, as did the euro against the dollar. Normally it is the U.S. dollarthat gains in international crisis. But this time, with the attack centeringon New York, foreign traders were unsure which direction to go.When the New York Stock Exchange reopened the following Monday, September 17, the Dow Industrials fell 685 points, or 7.13 percent,the fourteenth-largest percentage drop in its history. The Dow continuedto fall during the week and closed Friday, September 21, at 8,236—downmore than 14 percent from its September 10 close and nearly 30 percentfrom its all-time high of 11,723 reached on January 14, 2000.
WHAT MOVES THE MARKET?It was vividly clear why the markets fell after the terrorist attacks. But itmight surprise investors that in the vast majority of cases, major marketmovements are not accompanied by any news that explains why priceschange. Since 1885, when the Dow Jones averages were first formulated,there have been 126 days when the Dow Jones Industrial Average haschanged by 5 percent or more. Of these, only 30 of these major movescan be identified with a specific world political or economic event, suchas wars, political changes, or governmental policy shifts. That meansthat less than 1 in 4 major market moves can be clearly linked to a specific world event. A ranking of the 51 largest changes is shown in Table13-1a, and market changes greater than 5 percent that are associated
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TABLE
13–1a
Daily Changes over 5 Percent in the Dow Jones Industrial Average (Negative Changes Are Boldface,and Asterisks Denote Changes Associated with News Items; Excludes 15.34 Percent Change fromMarch 3 to 15, 1933, for U.S. Bank Holiday)Rank12*345678910*11*121314*15*1617
DateOct 19, 1987Oct 6, 1931Oct 28, 1929Oct 30, 1929Oct 29, 1929Sep 21, 1932Oct 21, 1987Nov 6, 1929Aug 3, 1932Feb 11, 1932Nov 14, 1929Dec 18, 1931Feb 13, 1932May 6, 1932Apr 19, 1933Dec 18, 1899Oct 8, 1931
Change-22.61%14.87%-12.82%12.34%-11.73%11.36%10.15%-9.92%9.52%9.47%9.36%9.35%9.19%9.08%9.03%-8.72%8.70%
Rank18192021222324*25*26*2728*2930313233*34*
DateAug 12, 1932Mar 14, 1907Oct 26, 1987Jun 10, 1932Jul 21, 1933Oct 18, 1937Sep 5, 1939Feb 1, 1917Oct 27, 1997Oct 5, 1932Sep 17, 2001Jun 3, 1931Jan 6, 1932Sep 24, 1931Jul 20, 1933Oct 13, 1989Jul 30, 1914
Change-8.40%-8.29%-8.04%7.99%-7.84%-7.75%7.26%-7.24%-7.18%-7.15%-7.13%7.12%7.12%-7.07%-7.07%-6.91%-6.90%
Rank35363738*3940*4142*4344*4546*4748495051*
DateJan 8, 1988Oct 14, 1932Nov 11, 1929May 14, 1940Oct 5, 1931May 21, 1940Mar 15, 1907Jun 20, 1931Jul 24, 1933Jul 26, 1934Dec 20, 1895Sep 26, 1955Jun 19, 1933May 10, 1901Oct 23, 1929Aug 6, 1932Jul 26, 1893
with specific events are shown in Table 13-1b.1 Monetary policy is thebiggest single driver of these massive market outbreaks of euphoria orfear. Out of the 5 largest moves in the stock market over the past centuryfor which there is a clearly identifiable cause, 4 have been directly associated with changes in monetary policy.If you focus in on just the 10 largest daily market moves since 1885,only 2 can be attributed to a specific news event. The record 22.6 percentone-day fall in the stock market on October 19, 1987, is not associatedwith any one readily identifiable news event. In more recent years, since1940, there have been only four days of big moves where the cause isidentified: the 7.13 percent drop on September 17, 2001, when the markets reopened after the terrorist attacks; the 7.18 percent drop on October 27, 1997, when there was an attack on the Hong Kong dollar; the 6.91percent drop on Friday, October 13, 1989, when the leveraged buyout ofUnited Airlines collapsed; and the 6.54 percent drop on September 26,1955, when President Eisenhower suffered a heart attack. The decline inOctober 1989, although often attributed to the collapse of the leveraged1This expands the research originally published in David M. Cutler, James M. Poterba, andLawrence H. Summers, “What Moves Stock Prices,” Journal of Portfolio Management, Spring 1989,pp. 4–12.
Change-6.85%6.83%-6.82%-6.80%-6.78%-6.78%6.70%6.64%6.63%-6.62%-6.61%-6.54%6.38%6.36%-6.33%6.33%-6.31%
CHAPTER 13 When World Events Impact Financial Markets
TABLE
225
13–1b
Largest News-Related Movements in the Down Jones Industrial Average (Negative Changes AreBoldface)Rank21011141524252628333438404244465165666773768588899395104125126
DateOct 6, 1931Feb 11, 1932Nov 14, 1929May 6, 1932Apr 19, 1933Sep 5, 1939Feb 1, 1917Oct 27, 1997Sep 17, 2001Oct 13, 1989Jul 30, 1914May 14, 1940May 21, 1940Jun 20, 1931Jul 26, 1934Sep 26, 1955Jul 26, 1893Oct 31, 1929Jun 16, 1930Apr 20, 1933May 2, 1898Mar 28, 1898Dec 22, 1916Dec 18, 1896Feb 25, 1933Oct 23, 1933Dec 21, 1916Apr 9, 1938Oct 20, 1931Mar 31, 1932
Change14.87%9.47%9.36%9.08%9.03%7.26%-7.24%-7.18%-7.13%-6.91%-6.90%-6.80%-6.78%6.64%-6.62%-6.54%-6.31%5.82%-5.81%5.80%5.64%5.56%5.47%-5.42%-5.40%5.37%-5.35%5.25%5.03%-5.02%
News HeadlineHoover Urges $500M Pool to Help BanksLiberalization of Fed discount policyFed Lowers Discount Rate/Tax Cut ProposedU.S. Steel Negotiates 15% Wage CutU.S. Drops Gold StandardWorld War II Begins in EuropeGermany announces unrestricted submarine warfareAttack on Hong Kong DollarWorld Trade Center and Pentagon Terrorist AttacksUnited Airline Buy-out CollapsesOutbreak of World War IGermans Invade HollandAllied Reverses in FranceHoover Advocates Foreign Debt MoratoriumFighting in Austria; Italy mobilizesEisenhower Suffers Heart AttackErie Railroad BankruptFed Lowers Discount RateHoover to Sign Tariff BillContinued Rally on Dropping of Gold StandardDewey Defeats SpanishDispatches of Armistice with SpainLansing Denies U.S. Near WarSenate votes for Free CubaMaryland Bank HolidayRoosevelt Devalues DollarSec. of State Lansing implies U.S. Near WarCongress Passes Bill Taxing U.S. Government Bond InterestICC Raises Rail RatesHouse Proposes Stock Sales Tax
buyout, can be questioned since the market was already down substantially on very little news before the collapse was announced.War is usually the biggest market mover. But the market drop onSeptember 17, 2001, was more than twice the 3.5 percent drop that occurred on the day following the attack on Pearl Harbor, and it was morethan that of any other one-day decline during a period when the UnitedStates was officially at war.
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Even when news has occurred, there can be sharp disagreementover what news caused the market change. On November 15, 1991, whenthe Dow fell over 120 points or nearly 4 percent, Investor’s Business Dailyran an article about the market entitled “Dow Plunges 120 in a ScaryStock Sell-off: Biotechs, Programs, Expiration and Congress Get theBlame.”2 In contrast, the London-based Financial Times published afront-page article written by a New York writer entitled “Wall StreetDrops 120 Points on Concern at Russian Moves.” What is interesting isthat such news, specifically that the Russian government had suspendedoil licenses and taken over the gold supplies, was not mentioned evenonce in the Investor’s Business Daily article! That one major newspapercan highlight “reasons” that another does not even report illustrates thedifficulty of finding fundamental explanations for the movements ofmarkets.
UNCERTAINTY AND THE MARKETThe stock market hates uncertainty, which is why events that jar investors from their customary framework for analyzing the world canhave devastating effects. September 11 serves as the perfect example.Americans were unsure what these terrorist attacks meant for the future.How severe would the drop in air travel—or any travel—be? How big ahit would the approximately $600 billion tourist industry take? Unanswered questions generate anxiety and declining prices.Uncertainty about the presidency is another downer. The marketalmost always declines in reaction to sudden, unexpected changes related to the presidency. As noted previously, President Eisenhower’sheart attack on September 26, 1955, caused a 6.54 percent decline in theDow Industrials, the seventh largest in the postwar period. The dropwas a clear sign of Eisenhower’s popularity with investors. The assassination of President Kennedy on Friday, November 22, 1963, caused theDow Industrials to drop 2.9 percent and persuaded the New York StockExchange to close two hours early to prevent panic selling. Trading remained suspended the following Monday, November 25, for Kennedy’sfuneral. Yet, the following Tuesday, by which time Lyndon Johnson hadtaken over the reins of government, the market soared 4.5 percent, representing one of the best days in the postwar period.When William McKinley was shot on September 14, 1901, the market dropped by more than 4 percent. But stocks regained all of their losses2
Virginia Munger Kahn, Investor’s Business Daily, November 16, 1991, p. 1.
CHAPTER 13 When World Events Impact Financial Markets
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on the following trading day. The death of Warren Harding in 1923caused a milder setback, which was soon erased. Sell-offs such as theseprovide good opportunities for investors to buy stocks since the marketusually reverses itself quickly following the change in leadership.3
DEMOCRATS AND REPUBLICANSIt is well known that the stock market prefers Republicans to Democrats.Most corporate executives and stock traders are Republicans, and manyRepublican policies are perceived to be favorable to stock prices andcapital formation. Democrats are perceived to be less amenable to favorable tax treatment of capital gains and dividends and more in favor ofregulation and income redistribution. Yet the stock market has actuallydone better under Democrats than Republicans.The performance of the Dow Jones Industrials during every administration since Grover Cleveland was elected in 1888 is shown in Figure 13-2. The greatest bear market in history occurred during HerbertHoover’s Republican administration, while stocks did quite well underFranklin Roosevelt, despite the fact that the Democrat was frequently reviled in boardrooms and brokerage houses around the country. The immediate reaction of the market—the day before the election to the dayafter—does indeed conform to the fact that investors like Republicansbetter than Democrats. Since 1888, the market fell an average of 0.5 percent on the day following a Democratic victory, but it rose by 0.7 percenton the day following a Republican victory. But the market’s reaction tothe Republicans’ success in presidential elections has been muted sinceWorld War II. There have been occasions, like Clinton’s second-termelection victory, when the market soared because the Republicans keptcontrol of Congress, not because Clinton was reelected.It is also instructive to examine the returns in the first, second,third, and fourth years of a presidential term, which are displayed inTable 13-2. The returns in the third year of a presidential term are clearlythe best, especially since 1948. It is striking that this is true since the thirdyear includes the disastrous 43.3 percent drop that occurred in 1931, during the third year of Hoover’s ill-fated administration and the worst 1year performance in more than 120 years.Why the third year stands out is not clear. One would think that thefourth year of a presidential term, when the administration might in3
But there are some whom the market never forgives. Stocks rallied over 4 percent in the week following the news of the death of Franklin Roosevelt, who was never a favorite on Wall Street.
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FIGURE
13–2
The Dow Jones Industrial Average and Presidential Terms (Vertical Lines Represent a Change ofAdministration, Dark Lines Represent a Change of Party, and Shaded Areas Represent a DemocraticPresident in Office)
crease spending or put pressure on the Fed to stimulate the economy forthe upcoming election, would be the best year for stocks. But the fourthyear, although good, is clearly not the best. Perhaps the market anticipates favorable economic policies in the election year, causing stockprices to rise the year before.The superior performance under the Democrats in recent years isdocumented in Table 13-3. This table records the total real and nominalreturns in the stock market, as well as the rate of inflation, under Democratic and Republican administrations. Since 1888, the market has faredbetter in nominal terms under Democrats than under Republicans, butsince inflation has been lower when the Republicans have held office,real stock returns have been slightly higher under Republicans than
CHAPTER 13 When World Events Impact Financial Markets
TABLE
229
13–2
Stock Returns during Presidential Administrations (Measured in Percent by S&P Total Returns Index;Italics Represent Democratic Administrations)President'sPartyName
ElectionDate
Harrison
11/6/1888
R
From: 1 day beforeTo: 1 day after
First Year
Second Year
Third Year
Fourth Year
of Term
of Term
of Term
of Term
0.4-0.52.73.31.32.41.8-0.4-0.61.21.2-4.52.3-2.4-0.3-3.80.4-0.90.8-0.20.3-0.1-1.01.7-0.9-0.4-0.92.6-1.61.1
6.9-19.120.219.721.316.4-5.1-18.59.225.7-8.454.0-35.0-11.636.418.8-1.0-10.826.912.5-8.5-14.7-7.2-4.932.231.510.033.4-11.98.4
-6.23.229.18.30.8-3.6-5.917.129.611.6-24.9-1.431.120.3-8.131.752.643.4-8.7-10.14.0-26.56.621.418.5-3.21.328.6-21.9
18.75.03.8-17.4-24.53.431.119.65.137.5-43.347.7-0.425.95.724.031.612.022.824.014.337.218.422.55.230.537.621.028.7
6.23.021.231.438.97.38.7-14.326.643.6-8.233.9-9.819.85.518.46.60.516.511.119.023.832.46.316.87.723.0-9.112.8
-0.50.70.2-0.4-0.0-0.2
7.37.77.615.72.37.6
8.19.38.58.213.010.2
21.710.315.424.622.823.6
10.716.313.815.411.713.3
ClevelandD11/8/1892McKinleyR11/3/1896McKinleyR11/6/1900Roosevelt, T.R11/8/1904TaftR11/3/1908WilsonD11/5/1912WilsonD11/7/1916HardingR11/2/1920CoolidgeR11/4/1924HooverR11/6/1928Roosevelt, F.D11/8/1932Roosevelt, F.D11/3/1936Roosevelt, F.D11/5/1940Roosevelt, F.D11/7/1944TrumanD11/2/1948EisenhowerR11/4/1952EisenhowerR11/6/1956KennedyD11/8/1960JohnsonD11/3/1964NixonR11/5/1968NixonR11/7/1972CarterD11/2/1976ReaganR11/4/1980ReaganR11/6/1984Bush, G. H. W.R11/8/1988ClintonD11/3/1992ClintonD11/5/1996Bush, G. W.R11/7/2000*Bush, G. W.R11/7/2004*Outcome of race was officially undetermined until December 13, 2000
Average from1888 to 2006
Democratic
Average from1948 to 2006
Democratic
RepublicanOverallRepublicanOverall
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PART 3 How the Economic Environment Impacts Stocks
TABLE
13–3
Presidential Administrations and Stock Returns (Stock Returns Taken from Election Date or Date ofTaking Office, Whichever Is Earlier; Italics Represent Democratic Administrations)Months AnnualizedinPartyDateNominalOffice Stock ReturnHarrisonR11/88 - 10/92485.74ClevelandD11/92 - 10/9648-3.31McKinleyR11/96 - 8/015820.66Roosevelt, T.R9/01 - 10/08864.81TaftR11/08 - 10/12487.54WilsonD11/12 - 10/20964.68HardingR11/20 - 7/23335.48CoolidgeR8/23 - 10/286328.04HooverR11/28 - 10/3248-20.42Roosevelt, F.D11/32 - 3/4514911.52TrumanD4/45 - 10/529114.66EisenhowerR11/52 - 10/609614.96KennedyD11/60 - 10/633615.15JohnsonD11/63 - 10/686010.39NixonR11/68 - 7/7469-1.32FordR8/74 - 10/762717.21CarterD11/76 - 10/804811.04ReaganR11/80 - 10/889615.18Bush, G. H. W.R11/88 - 10/924814.44ClintonD11/92 - 10/009619.01Bush, G.W.R11/00 - 12/01741.62Democrat44.0%10.85Average from 1888 toRepublican 56.0%8.59October 2006Overall100%9.58Democrat42.1%15.26Average from 1948 toRepublican 57.9%9.71October 2006Overall100%12.01President’sName
AnnualizedInflation0.04-1.910.001.390.829.42-4.050.12-6.292.365.541.351.112.776.037.2710.024.464.222.582.514.121.572.693.643.783.72
under Democrats. But this has not been true over the past 60 years, whenthe market performed far better under the Democrats whether or not inflation is taken into account. Perhaps this is why the market’s reaction toa Democratic presidential victory has not been as negative in recentyears as it was in the past.
AnnualizedRealReturn5.70-1.4320.663.386.67-4.339.9327.88-15.088.948.6413.4213.887.42-6.939.270.9310.269.8116.01-0.876.496.916.7111.275.717.99
CHAPTER 13 When World Events Impact Financial Markets
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STOCKS AND WARSince 1885, the U.S. economy has been at war or on the sidelines of aworld war about one-fifth of the time. The stock market does equallywell in nominal returns whether there is war or peace. Inflation, however, has averaged nearly 6 percent during wartime and less than 2 percent during peacetime, so the real returns on stocks during peacetimegreatly outstrip those during wars.While returns are better during peacetime, the stock market has actually been more volatile during peacetime than during war, as measured by the monthly standard deviation of the Dow Industrials. Thegreatest volatility in U.S. markets occurred in the late 1920s and early1930s, well before the United States was engaged in World War II. Onlyduring World War I and the short Gulf War did stocks have highervolatility than the historical average.In theory, war should have a profound negative influence onstock prices. Governments commandeer tremendous resources,while high taxes and huge government borrowings compete with investors’ demand for stocks. Whole industries are nationalized to further the war effort. Moreover, if losing the war is deemed apossibility, stocks could well decline as the victors impose sanctionson the vanquished. However, the economies of Germany and Japanwere quickly restored to health following World War II, and stockssubsequently boomed.
The World WarsThe market was far more volatile during World War I than during WorldWar II. The market rose nearly 100 percent during the early stages ofWorld War I, then fell 40 percent when the United States became involved in the hostilities, and finally rallied when the Great War ended.In contrast, during the six years of World War II, the market never deviated more than 32 percent from its prewar level.The outbreak of World War I precipitated a panic, as European investors scrambled to get out of stocks and into gold and cash. After Austria-Hungary declared war on Serbia on July 28, 1914, all the majorEuropean stock exchanges closed. The European panic spread to NewYork, and the Dow Jones Industrials closed down nearly 7 percent onThursday, July 30, the most since the 8.3 percent drop during the Panicof 1907. Minutes before the opening of the New York Stock Exchange onFriday, the exchange voted to close for an indefinite period.
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The market did not reopen until December. Never before had theNew York Stock Exchange been closed for such an extended period, norhas it since. Emergency trades were permitted, but only by approval of aspecial committee and only at prices at or above the last trade before theexchange closed. Even then, the trading prohibition was observed in thebreach as illegal trades were made outside the exchange (on the curb) atprices that continued to