Investors, badly battered by a three-year bear market, have been discouraged to see stocks begin the new year with a renewed decline. The major averages all closed Monday below their year-end levels. Uncertainty about the prospect of a war with Iraq is a major factor in investor thinking, and uncertainty is always a negative for the market. The question follows: If the United States attacks, as is widely expected, will that mark the end of the decline?
The hoped for answer, of course, is yes. It is expected that the market will follow the precedent set in 1991 when the start of the Gulf War was followed by a strong rally which, in that case, basically continued for the rest of the decade. Lifting of the uncertainty may also free up some business spending plans, reinforcing an upward trend in the market.
However, while there are similarities in the two situations, the overall environment today is very different from the one that prevailed twelve years ago.
The start of the 1990s marked the midpoint of a twenty-year bull market that by the end of the decade arguably developed into the greatest financial mania in history. That bull market is now just a memory and investors are today confronted with its aftermath — which is still unfolding. History provides numerous examples of what happens when financial bubbles burst. One can look at the tulip craze that swept Holland in the seventeenth century, the speculation of the Roaring Twenties in this country, and the Japanese boom of the 1980s. They all share one common characteristic in their conclusions: All the gains were lost. There has never been an exception.
Great bull-to-bear cycles do not end when securities are still high priced by historical standards, as they are today. At a minimum they end with prices somewhere near normal valuation levels. Mean price-to-earnings ratios in U.S. markets over the last century are found in the middle teens. Ratios today, even assuming reasonable growth in the economy this year, are over twenty, and there are some indications that growth may be below average.
The military task ahead is also not exactly comparable to that faced by our forces in 1991. Then the objective was simply to force Saddam Hussein to withdraw from Kuwait. After an extensive air campaign, that was rapidly accomplished when mechanized forces swept through the Iraqi desert against an army caught in the open. This time our troops may face the prospect of urban fighting against an enemy who is likely to surround himself with civilians. The outcome will not be in doubt, but the conflict may take longer than the last time and involve more casualties. Any early setbacks or uncertainty over the course of the conflict will limit a positive response in the financial markets.
The post-war task will also be very different. After the Gulf War we made Saddam promise to disarm and then went home. The aftermath this time will be far more complicated and present a new set of challenges and risks. In addition, the war against terror will not end in Baghdad, so the resolve of the United States will continue to be tested.
A reasonable conclusion to all of this is that a short war with a positive outcome will undoubtedly be well received on Wall Street. However, unlike the last time, serious challenges to our security will remain and the market background will be negative — as we will not have finished wringing out the excesses of the late and now lamented bull cycle. It will be no time to throw caution to the wind.
— Tappen Soper is a writer and private investor in Lyme, Connecticut.