Wall Street reacts to any surprises

By DAVID MOON, Moon Capital Management
August 8, 2004

If every investor in the US was convinced the Dow Jones Industrial Average would increase from 10,000 to 20,000 in the next 20 months, what do you think would happen? Would investors be content to sit around and wait for the increase to start? Of course not. Anyone convinced of an impending Dow double would try to beat the rush and load up on stocks. Why wait for an event you know will happen?
This is known as a self-fulfilling prophecy. This phenomenon is a powerful force, but only in the short term. (In the long term, stock prices move in reaction to changes in the values of the businesses underlying a particular stock, not emotional factors.)

When information is known, the effect of that information is usually already factored into the investments' prices. In the short term, the market reacts to surprises, not already expected events. If there were no surprises on Wall Street, it would be a dull place. It would certainly be less volatile.

In 1990, Sadaam Hussein invaded neighboring Kuwait, precipitating the first Persian Gulf War. (Well, it wasn't actually the first war in the Persian Gulf, since they've been fighting almost constantly since the days of sticks and stones.)

Congress eventually voted to demand Iraqi withdrawal from Kuwait by January 15, 1991. When the dictator balked, five weeks of nightly coalition bombing raids severely damaged the Iraqi Republican Guard's ability and willingness to fight.

On February 23, the US ground invasion began, lasting a mere 100 hours before liberating Kuwait. The timing of the start of this war was known with almost the same predictability as the broadcast time of the nightly news. When the highly anticipated ground war commenced, how did the US stock market react? Fear? No. Concern? Maybe. Panic? Certainly not. The most common reaction was relief and opportunism. The Dow Jones Industrial Average declined less than one-tenth of one percent the day the ground war started. It increased 20 percent from the start of the war to the end of the year. So much for the war panic.

The war bear market reaction occurred in late 1990, in anticipation of the war with Iraq. During three months in the fall of 1990, the DJIA declined 20 percent, all before the war. Once the war started, there were no surprises, other than the swiftness of the Iraqi retreat.

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Following the September 11, 2001 attacks, stock prices initially reacted with shock. Virtually no investors anticipated this sort of attack on American soil, so the event clearly met the definition of a surprise. The stock market hates bad surprises. Ergo, the market was crushed.

National polls indicate that two-thirds to 80 percent of Americans expect another terror attack on US soil. I guarantee you that the workers in lower Manhattan expect more attempts. The next attack will be a shock, but it won't be a surprise.

It is dangerous to try and predict short-term market movements, but I wonder how the stock market will react?

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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