There will be another terrorist attack on U.S. soil that’s as traumatic as the World Trade Center attack on Sept. 11, 2001. We just don’t know when.
We should plan now for how we will react when that crisis occurs, rather than react out of fear and panic. To start, it’s helpful to look at the U.S. stock market’s performance after the 9/11 terrorist attack on the World Trade Center in 2001. For example, at its low, five trading sessions after the attack, the Dow Jones Industrial Average DJIA, +0.55% was 17.5% below where it had closed on Sep. 10. Yet the Dow quickly recovered, and by early November actually was higher than where it stood the day before those attacks, and by the subsequent March was higher still.
A lucky turn of events? No — U.S. stocks typically bounce back following spasms of panic-induced selling.
Consider all the times since the Dow was created in the late 1890s (other than September 2001) in which it fell by at least 17.5% over a five-trading-day period. On average following those plunges, the Dow one month later was 5.2% higher. One year following those plunges the Dow was 23% higher, on average. Accordingly, the Dow at the end of such a five-day plunge often is at or near a low, and within a year has completely reversed the damage.
In the wake of the September 2001 terrorist attacks, the Dow was stronger than these historical averages over the subsequent month-, quarter-, and six-month period, while weaker over the full 12-month period. (See chart, below.) I judge this as being largely consistent with the historical averages, since the downturn came in the middle of a bear market precipitated by the bursting of the internet bubble. From that perspective, it’s remarkable that the Dow was as strong as it was over the month-, quarter-, and six-month period following the 9/11 attacks.
Rational versus behavioral
The Dow’s quick bounceback after a huge plunge certainly appears to be evidence that investors overreact. They panic, selling first and asking questions later. Then, when cooler heads prevail, the market recovers.
To be sure, there is an alternate explanation for the Dow’s behavior that is important to acknowledge, since its investment implication is far different. What if the market’s initial plunge following a crisis was entirely rational, discounting an ever more terrible future? In that case, the market’s quick recovery simply meant that things didn’t turn out as bad as they could have. That lucky turn of events is hard to extrapolate into the future.
What if, for example, there was a 50% probability that the 9/11 terrorist attacks meant that corporate America was worth 35% less than before the attacks? The 17.5% actual decline would therefore have been an entirely rational response. Likewise, it would have been entirely rational for the stock market to quickly recover as the dust settled and this 50% probability diminished.
This rational, as opposed to behavioral, explanation suggests that we should not expect the market to quickly recover from future plunges. Just because we were lucky in the past doesn’t mean we’ll be lucky in the future.
But I come down on the behavioral side of this rational-versus-behavioral debate, since there is ample evidence that investors overreact. So it’s hardly a stretch to assume that they do so as well in the face of crises like the 9/11 attacks.
For example, it’s well known in academic circles that worst-performing stocks over a trailing five-year period do significantly better over the subsequent five years than the best-performing stocks of that initial five-year period. Investor overreaction seems the most obvious explanation for this pattern.
The rational-versus-behavioral debate is far from settled, however. Even if it were, there are no guarantees that the future will be like the past.
But, to the extent you agree that the market overreacts, you should resolve now not to sell into any panic precipitated by another terrorist attack. Gutsy contrarians might even want to buy stocks when the market declines.
Some may find it unseemly to even be thinking about money in the context of what will undoubtedly be a hugely traumatic event. But remember that you help no one by doing something stupid with your investments. In fact, doing nothing with your portfolio in the aftermath of an attack can free you to be more helpful than you might be otherwise.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com. Create an email alert for Mark Hulbert’s MarketWatch columns here (requires sign-in).
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