‘Right’ Financial Response to Sept. 11 Remains Unclear

The history of financial markets is a history of one question asked repeatedly in retrospect: “What on Earth were people thinking?”

With the passage of time, the herd mentality of investors at key market inflection points inevitably appears so wrong-headed as to seem absurd.

So it was with the panic selling of stocks in October 1987, for example, and the panic buying of anything Internet-related in 1999.

But one year after the terrorist attacks, it is far from clear what constituted the “right” investor reaction to the attacks, and what might be labeled a mistake.

The problem for markets, as for the nation as a whole, is that too many of the questions raised by the attacks remain unresolved, and may stay unresolved for a long time. That makes it difficult to say that any money decision made in the aftermath--or any change in the long-term outlook for investment returns--was right or wrong.

To be sure, stock prices in general are lower today than they were on Sept. 10, when an attack of the magnitude of what occurred the next day was inconceivable to most Americans.

The Dow Jones industrial average closed at 9,605.51 on Sept. 10. When trading reopened Sept. 17, the Dow dived 684.81 points, or 7.1%, to end at 8,920.70. The market continued to fall for the rest of that week as many investors fled. On Friday Sept. 21, the Dow closed at 8,235.81. It had fallen 14.3% for the week, the second-worst weekly loss since at least 1915.

But the next week the market began to rebound, and it mostly continued to do so through December. Wall Street’s optimists said the market correctly foresaw that the allied invasion of Afghanistan would succeed in routing the Taliban and that the U.S. economy would not fall into the depression that many initially had feared.

Yet the fourth-quarter rally wasn’t sustainable. By spring, the bear market that began in March 2000 was again in full effect. By midsummer, major stock indexes were at five-year lows.

The market rallied for much of August but has struggled in the last two weeks. The Dow lost 2.7% last week to end at 8,427.20. That left it 12.3% below the close on Sept. 10 of last year.

The broader Standard & Poor’s 500 index is 18.2% below its Sept. 10 close; the tech-heavy Nasdaq composite is down 23.6%.

But measured from its close on Sept. 21, the low point after the attacks, the Dow is up 2.3%. In the same period, the S&P 500 is down 7.4% and the Nasdaq is off 9%.

So share prices fell substantially in the first reaction to the attacks, but today they aren’t much below the worst levels of that sell-off.

How much, then, has a fear factor specifically related to the attacks, or to worries about more attacks, depressed stocks since the initial sell-off? After all, the market has had more than terrorism to fret about since September. The economy’s health remains a big question, and the wave of corporate scandals has almost certainly helped to depress stocks.

“I doubt that equity prices would be sizably different today without Sept. 11,” said James Gipson, co-manager of the Clipper Fund in Beverly Hills and a well-known “value” stock picker. “The bear market started long before Sept. 11, and for very good reasons.”

Some Wall Street pros argue that the market might have suffered a worse decline had the attacks never occurred. They note that stocks had been plummeting in August and early September 2001 on worries that the economy’s recession was deepening.

The attacks assured that Uncle Sam, and central banks worldwide, would quickly “open all the faucets” to keep the global economy afloat, said Ned Riley, investment strategist at State Street Global Advisors in Boston.

The economy, and the stock market, also may have been helped in the immediate aftermath of the attacks by the wave of patriotism that swept the nation. As markets reopened the week of Sept. 17, the Internet buzzed with e-mails from small investors urging each other to buy stocks, not sell them. To sell was to play into the terrorists’ hands, many said.

Likewise, the fact that consumer spending did not collapse in the fourth quarter may owe at least in part to Americans’ sense that staying home, with wallets closed, would have aided the enemy.

But if the fear factor related to terrorism has hurt stocks less than investors might have imagined--perhaps because that fear has hurt the economy less than expected--it is clear that more people are placing a higher premium on safety of principal.

That is why the price of gold is up 17.5% since Sept. 10, why the sum in safe but boring bank savings accounts has mushroomed, and why yields on Treasury securities have fallen to 40-year lows.

What’s more, many investors have substantially lowered their expectations for portfolio returns in the near term. A monthly survey of investors by brokerage UBS and the Gallup Organization showed that, in August, the average expected return over the next 12 months was 7.4%, the lowest since the survey began in June 1998.

Stock market bulls take heart from those lowered expectations: If investors aren’t expecting much from equities, there is a greater chance that they’ll be pleasantly surprised, which in turn could attract more money to stocks.

Barton Biggs, veteran investment strategist at Morgan Stanley in New York, recently put it this way in a note to clients: “After a big decline, the news doesn’t have to be good for the stock market to rise. It just has to be less bad than what has already been discounted.”

But the issue of how much has been discounted in stock prices--that is, how much potential disappointment and turmoil already is reflected in the market’s current level--is the great unknown. Times are always uncertain, of course, but the uncertainties today loom very large indeed.

For example, do share prices already reflect the possibility that the Bush administration will decide to go to war with Iraq?

What effect would another devastating terrorist attack on U.S. soil have on investors’ willingness to hold stock, or buy more? (To own stock, after all, requires confidence in the future.)

Will there be a ceiling on stock prices for years to come because of the now-ingrained fear of terrorism? How low is that ceiling?

To give the bulls their due, absent a new war or another attack it’s also reasonable to ask whether the market, still near five-year lows, is priced more for the possibility of a weak economy and less for the possibility of decent growth in 2003.

And how many points might the Dow rise in one day if it were announced that Osama bin Laden had been captured?

There are many smart people on Wall Street who believe stock prices should be lower overall to reflect the myriad risks faced by the economy and the markets.

One is Bill Gross of Pacific Investment Management Co. in Newport Beach. As one of the world’s best-known bond investors, Gross arguably has an ax to grind for bonds and a reason to dislike stocks. In his latest note to clients, he slams the equity market.

“Stocks stink and will continue to do so until they’re priced appropriately,” he said. What’s appropriate? Gross said the Dow could fall as low as 5,000 before the market would provide genuine value.

Gross’ take isn’t shared by Gipson. He views the market as “somewhat reasonably valued” now. “We’re finally starting to see cheap stocks to buy,” he said.

For the individual investor, the “correct” reaction to Sept. 11 and the new realities it ushered in may have nothing to do with guessing the investments that will perform best from now on. It has everything to do with choosing an investment mix that allows you to sleep well at night.