Most Mexican commuters won't be thinking about stock prices
Deciding how to react to a crisis like a potential flu pandemic, a natural disaster or war is one of the most controversial aspects of stock market investing.
Many panics, whether they affect the whole market or individual companies, turn out to be false alarms.
Even those scares that have substance often turn out to be less important than the market first anticipated.
In this article, I’ll divide panic scenarios into three categories, and discuss how I personally react to such scare stories when investing.
Of course, if you’re a passive buy-and-hold index investor, your response is clear. Just keep putting money into your fund regardless every month, and let the volatility boost your returns!
Get some perspective on the crisis
One of my favourite possessions is a graph showing the rise of equities over the past 100 years, set against a timeline of historical events.
A quick glance shows momentous events are very rarely correlated with meaningful stock market moves. The market rises or falls according to its own cycle of fear and greed, not the history books.
Even when events do seem correlated, the market’s response can be the opposite of what you’d expect.
For instance, the U.S. ceasefire in Vietnam ended a devastating and unpopular war, yet it coincided with a period of plunging markets. In contrast, when the crippled UK economy received a humiliating £2.3 billion bailout from the IMF in the mid-1970s, the market soared upwards, at least in nominal terms.
In both instances, ongoing bull and bear market cycles were more important than historically significant events.
Nevertheless, a good panic gets many traders’ hearts racing, and anecdotes about fortunes being made by quick thinking are commonplace.
And why shouldn’t a crisis affect a stock’s fortunes? The market is after all a collection of companies that operate in and are affected by events in the real-world, not on trading screens. If the crisis affects company earnings, then it will certainly affect their share prices.
Given these caveats and the potential for opportunity, let’s divide crisis scenarios into three main kinds:
- Vague global or market-wide panics (see below)
- Specific news events (see part two)
- A company-specific crisis (to be discussed in part three)
1. Vague global or market-wide panics
As I write, the world is panicking about an outbreak of swine flu that has claimed 100 lives in Mexico. New cases have already been reported as far apart as Canada and New Zealand.
Sounds familiar? A few years ago it was avian bird flu spreading alarm. Happily sheep, cows, cats and dogs don’t appear to get flu, otherwise we’d be in a perpetual state of terror.
I happen to believe a new and untreatable infectious disease is a big threat to millions of lives. A flu pandemic in 1918 killed an estimated 50 million people worldwide, while another killed millions in Asia in 1957. Air travel and population growth has probably offset the benefits of better screening and medicine in combating flu since then.
In short, I think it’s virtually certain we’ll suffer another flu pandemic. But judging when is another matter. It’s a bit like your own mortality – you can be 100% sure you’ll die, but it’s not likely to happen tomorrow.
What’s more, how do you calculate the affect of such a flu pandemic on the global economy?
Crass as it may sound to say it in the face of such a human tragedy, even 50 million deaths isn’t massive, economically-speaking, in the context of a population of over six billion.
More devastating than death would likely be the preventative measures introduced to control the disease.
Disruption to workplaces and industry as nations closed their borders and quarantined their populations would certainly have a huge impact on global GDP, and the reliance of some countries on food imports could be as serious a threat as the initial disease.
In the face of such unknowns, the market starts to guess, and errs on the cautious side: As I type shares in British Airways have fallen over 8%, while the price of drug maker GlaxoSmithkline is up nearly 4%.
As hedging strategies, such trades make some sense, and they certainly show the market operating as a discounting machine, just as the textbooks predict.
But if the swine flu panic subsides just as all the previous scares have, then anyone selling British Airlines at a knock-down price out of fear will be sorry.
What to do in a global panic?
Generally, I think vague and panicky situations are best ignored, or else considered an opportunity to buy the whole market.
This isn’t because a flu pandemic, say, wouldn’t affect company earnings, but because its likelihood and the consequences are pretty much impossible for individuals to evaluate, leaving us prey to news reporting and panic.
Why consider buying? Stock markets hate uncertainty. Will swine flu spread? Will millions die? If they do, then from an economic perspective will it be as bad as the worst estimates? Or would it make little difference to the already battered expectations of company earnings?
If you buy shares knowing that nobody knows the answers to such questions but that many investors will overreact, then panics may enable you to buy cheap equities – always understanding that someday a panic will prove prescient, and you’d better be diversified when that day comes!
To be sure of catching all of this series, subscribe (for free) to Monevator in your RSS feed or via email.
Comments on this entry are closed.