Will Your Portfolio Become a Prisoner of War?

Lessons From History and Psychology

Brett N. Steenbarger, Ph.D.
www.brettsteenbarger.com

This is a draft of an article that appeared on the MSN Money website

(www.moneycentral.com) in February, 2003.

War is good for the economy. The market is retreating on war fears.
Investors often entertain contradictory notions regarding the impact of war upon their
portfolios. Many look to the last Gulf War for guidance, expecting that market prices will
decline before the first shots are fired, only to rebound thereafter. If this is the way
markets typically respond to war, the current prewar environment may present
opportunities. Conversely, prewar bullishness may merely reflect the availability
heuristic described by Amos Tversky and Daniel Kahnemann, where we base our
conclusions on only the most available, recent wartime data.
How do markets respond to international hostilities, and what might this mean for
current investors? In this article, I will touch upon psychological research on stress to
suggest that the relationship between stock market performance and wartime is a function
of uncertainty. As a proxy for the economic value of entire countries, markets discount
unfavorable or doubtful war outcomes and accord premiums to nations that succeed in
conflict. Indeed, a careful examination of the trajectory of equity prices during recent

wars suggests that the fortunes of markets and wars are closely intertwined, with
important implications for your portfolio.
Stress and Uncertainty
A large body of research finds that there is a curvilinear relationship between the
probability of negative outcomes and emotional stress. When the probability of receiving
an electric shock, for example, is close to zero, people feel safe and do not display such
stress responses as elevated heart rate, galvanic skin response (sweating), and stressrelated hormones. At the other extreme, when the probability of getting the shock is
close to 100%, individuals typically respond with coping measures and control their
stress response. When the prospect of being shocked is near 50%, however, there is
considerable uncertainty. Not knowing how or when to cope, the uncertain individual
displays highly elevated stress reactions. Indeed, uncertainty is so intolerable that even
experimental animals will choose a predictable powerful shock over an uncertain, but
lesser jolt.
Extending this research to markets leads to what might be called a Fortunes of
War Hypothesis: As a country becomes successful in its war efforts, investors will view
the future with greater certainty and optimism and reward that countrys markets with
increasing prices. When the outcomes of war look unfavorable or are unknown,
investors will shy away from the markets, resulting in decreasing prices.
Lets take a historical look at markets and wars and see how well this hypothesis
holds up.

Markets and Fortunes of War

World War II offers a dramatic illustration of the ways in which market outcomes
are linked to the fortunes of war. The Fortunes of War Hypothesis, for example, would
lead us to conclude that the market performance of the eventual war losers (the Axis
powers) would fall short of the performance of the winners (Allied powers). That,
indeed, appears to be the case.
According to data compiled by London Business Schools Elroy Dimson, Paul
Marsh, and Mike Staunton (Triumph of the Optimists; Princeton University Press, 2002),
the stock, bond, and bill markets of the U.S., U.K., and Switzerland significantly
outperformed the German, Italian, and Japanese markets during the decade from 19401949. As Table One indicates at the end of this article, the stock markets of the winners
showed positive real returns during the war and postwar years, and the markets of the
losers displayed negative real returns, partially due to the depreciation of the losers
currencies during the war.
An even more fine-grained analysis of wartime events in World War II supports
our hypothesis. Although the U.S. did not formally become involved in World War II
until 1941, the Dow Jones Industrial Average ($INDU) had been responding to war
events well before then. When Germany began its offensive against Western Europe in
May, 1940, resulting in the defeat of Belgium, Norway, and France, the Dow swooned
approximately 25% in two months. Following U.S. President Franklin Delano
Roosevelts declaration of an unlimited national emergency on May 27, 1941, the Dow
managed a small rally, but was unable to exceed the highs of the previous May.

On October 27th of that year, Roosevelt delivered his Navy Day speech, claiming
possession of a secret map that detailed Hitlers plans for a new world order, including
the Americas. Several days later, the U.S. destroyer Reuben James was sunk and two
weeks after that the House approved a revision to the Neutrality Act, paving the way for
U.S. participation in the war. Faced with new uncertainty and then the defeat at Pearl
Harbor, the Dow promptly began a two month, near-20% descent from its early October
peak: a peak that would not be exceeded until early 1943, after the war. It was not until
the turnaround battles of Midway in the Pacific (June, 1942) and El Alamein (November,
1942) that the Dow was able to sustain a rise from its bottom. Churchills later remark,
Before Alamein we never had a victory. After Alamein we never had a defeat neatly
summed up the Dows fortunes, which moved from a low of 92.92 in April, 1942 to
165.44 on April 30, 1945, with Hitlers suicide.
Later Wars and the Markets
Similar correlations between war outcomes and market fortunes can be observed
during the Korean, Vietnam, and Gulf Wars. The initial phase of the Korean war in late
June and early July, 1950 saw an immediate 10% decline in the Dow, with the North
Korean capture of Seoul, Inchon, and Taejon. With initial U.S. victories in August of
that year, the Dow recovered most of its losses that month. Market prices stayed in a
narrow range as the Communist Chinese took the offensive in November and December,
1950, but then rose above their start-of-war highs in early 1951, as U.N. forces recaptured
Inchon and Seoul. By the armistice signing on July 27th, the Dow stood at 259.23,
approximately 20% above its lows early in the war.

During the Vietnam War, the North Vietnamese Tet Offensive, which began on
January 31, 1968, represented a military success for the U.S. and South Vietnamese. It
was widely regarded as turning American sentiment against the war, however, as it
became clear that a protracted conflict was at hand. The Dow dropped nearly 10%
between January and March of that year, rebounding only after President Johnsons
surprise announcement at the end of that month that he was halting bombing and
declining to run for reelection. With the start of American troop withdrawal in June,
1969, growing public protest, and no victory in sight, the Dow began a descent of over
20% into May, 1970. Rising interest ratesin part an inflationary consequence of
monetary policy during the prolonged wartook a recessionary toll on the economy.
This toll continued through 1974, following the cease-fire agreement of January 27, 1973
and the resignation of a politically weakened President Nixon in August, 1974. By the
time Saigon fell to the Communist offensive on April 30, 1975, the Dow had put in its
bottomwell over 50% below its prewar highs in real terms.
The Gulf War, in many ways, was the reverse of the Vietnamese experience.
Commencing in August, 1990 with Iraqs invasion of Kuwait, the entire Desert Storm
campaignfrom January 16, 1991 to February 27th, lasted 43 days and resulted in a
clear-cut victory. Interestingly, the Dow made its bottom on October 11th in the days
following the Iraqi invasion but prior to the onset of U.S. military involvement. As it
became clear that world supportand military mightwas behind Kuwait and the U.S.,
the Dow rose over 4% the day following the start of battle and, by the end of hostilities,
had jumped over 15%.

Conclusions
Although the above relationships between markets and wars are suggestive, it
would be a mistake to assume that all market outcomes in wartime are attributable to the
fortunes of combat. It is true that U.S. market performance was sunnier following wars
in which we were either successful (World War II, Gulf War) or at least not unsuccessful
(Korean War) compared with the less favorable Vietnam years. Still, not all of this can be
attributed to wartime outcomes. The late 1960s and early 1970s, for example, were a
period of high worldwide inflation, resulting in negative real performance among many
world boursesincluding those of countries not directly involved in the Vietnam
conflict.
It may well be that unfavorable war outcomes only damage markets when they
take a significant political and economic toll, weakening a countrys leadership and
making it at least temporarily less desirableand more uncertainas an investment
haven. Post-Vietnam America, with its weakened Nixon leadership and high inflation
economy, would be a far less certain and attractive investment arena than post-Gulf War
America. A short, favorable war can be expected to bring greater certainty and optimism
to investors than a lengthy, unsuccessful conflict.
What are the implications for today? The earliest phases of war, in which
outcomes are most uncertain, have uniformly brought market declines. Only once it
becomes clear that war is proceeding toward a successful conclusion have those declines
been reversed. In the context of the current Iraq crisis, this means that we must ask the
question of what will constitute victory.

Unlike prior wars, the battle lines are unclearly drawn. If the enemy is Saddam
Hussein and the desired outcome is regime change, it is conceivable that this could be
accomplished relatively quickly, to the delight of the markets. While sorting out a postSaddam leadership may pose thorny political dilemmas and factional turmoil, this would
only affect the U.S. and world economies insofar as it undermines regional stability and
the vital oil markets.
The linkage of the Iraqi conflict to the War on Terrorism, however, makes it a
war within a war. It is not clear that the defeat of Hussein would imply the defeat of
terrorism and, indeed, it is conceivable that the radical Islamic response to a U.S. victory
in Iraq might include heightened terrorism. The markets would likely cheer the defeat of
terrorism with a response that would rival the post-war rallies of the 20th century. What
needs to happen to create the perception of such defeat, however, is not obvious. One
candidate is the wresting of oil revenues from regimes that directly or indirectly support
terrorist causes. To the degree that the pending war accomplishes that end in Iraq and
invokes the threat of similar consequences in neighboring countries, the War on Terrorism
might be able to claim its first decisive victory. This would considerably reduce investor
uncertainty, strengthen public support of the American President, and cheer the markets.
In themselves, however, individual victorieseven against Iraqwill not
necessarily defeat terrorism. This has been the experience of Israel, which has devoted
considerable resources to homeland security, with some notable success. Nonetheless, its
economy remains mired in a three-year recession with double-digit unemployment. Its
battle against terrorism appears unending, and its leadership has been battered. A rapid
victory against Iraq would no doubt buoy the markets. Until investors can construe such

victory as a turnaround in the War Against Terrorism and reduce their general uncertainty,
however, history suggests that gains will be constrained.

Brett N. Steenbarger, Ph.D. is an Associate Professor of Psychiatry and

Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and a daily
trader of the stock index futures markets. He is the author of The Psychology of Trading
(Wiley, 2003) and coeditor of the forthcoming The Art and Science of the Brief
Psychotherapies (American Psychiatric Press, 2004). Many of his articles on trading
psychology and daily trading strategies are archived at his website,
www.brettsteenbarger.com.

Table One
Real Returns of Markets During the Decade of World War II

Equities
U.S.
U.K.
Switzerland
Germany
Italy
Japan

4.0
3.1
4.0
(10.3)
(11.5)
(25.7)

Bonds
(2.1)
0.7
(1.0)
(20.8)
(27.6)
(35.2)

Bills
(4.7)
(2.0)
(2.9)
(2.4)
(29.7)
(32.9)

Inflation Rate
5.4
2.8
4.5
4.5
47.0
54.8