From the July 2011 issue of Investment Advisor • Subscribe!

What Really Moves Markets?

Disasters affect financial markets from Pearl Harbor to Fukushima, but what role does human behavior play in market successes and failures?

Historically, Americans have always been an optimistic lot, but there have certainly been times when optimism has yielded to its darker sibling, pessimism. This is never more true than when disaster strikes. Do the financial markets view disasters as a friend or enemy? Does fear among the masses create opportunity for the few? Are the events to which we ascribe market behavior fact or fiction? And, can we really know for certain?

What really moves markets and how has the stock market reacted to unforeseen, catastrophic events? Moreover, how do financial statistics, which typically reflect past events, impact human—and hence, market—behavior?

The effect that various disasters in the United States have had on stocks is influenced by multiple factors. For example, if the event levied a lofty price tag, but was localized and did not disrupt the “collective economic engine” to any significant degree, the market fallout was minimal. Moreover, if the economy was growing at the time of an event, momentum provided a helpful tailwind. Let’s begin with WWII and the reason we entered the fray.

[Click here for a list of the Dow's worst days.]

Pearl Harbor
It was near 70 degrees and partly cloudy in Honolulu on the morning of Sunday, Dec. 7, 1941. Just prior to 7:50 a.m.—the time when the Japanese pilots began their assault—U.S. military personnel and their families lay fast asleep after a Saturday night on the town. The next day, FDR addressed Congress and uttered the famous phrase, “A date which will live in infamy.” The United States was at war. In the wake of the attack, Pearl Harbor, and America for that matter, would never be the same.

The sad irony is that Americans held a strong “isolationist” belief at the time, and had it not been for the vicious assault on the U.S. naval base at Pearl, our introduction into WWII may have been delayed, perhaps even avoided.

For the 12 months prior to the attack, the average daily trading volume on the Dow Jones Industrial Average was about 560,000 shares. During the following three weeks, trading volume nearly tripled to 1.6 million shares per day. What was a bit surprising was its performance. With an event as serious as this, most would expect fear to reign and stocks to sell off with great fervor. Although stocks did decline, the rate of descent was far from severe. In fact, on the Friday before the attack, the DJIA had closed the day at 115.90. On the Monday after the attack, it lost 2.92%, closing at 111.53. On Tuesday, it fell to 107.56 for a loss of 2.89%. However, by the time Americans were singing “Auld Lang Syne,” the DJIA stood at 110.96, down less than 4.0%. The following year it rose 7.6%.

With America’s advent into the war, the economic engines began to hum. As factories retooled to manufacture tanks instead of trucks, planes instead of Pontiacs, the unemployment rate began to fall. The economy was on a path to recovery, and as corporate earnings grew, the stock market embarked on a 20-year binge.

Sept. 11, 2001
On Sept. 11, 2001, 19 al-Qaida terrorists commandeered four commercial passenger jets, set out to kill American citizens and crash the U.S. economy. Nearly 3,000 souls were lost that day in one of the most horrific events in recent history. This tragedy struck on the heels of a ruptured tech bubble and occurred during an already flagging economy. According to the National Bureau of Economic Research, the U.S. recession had officially begun six months earlier. After the second tower was struck, the stock market was closed, and remained closed for a week, as heroic volunteers sifted through the rubble hoping to find signs of life.

Already off 18% from its early 2000 peak, when the DJIA reopened the following Monday it fell an additional 7.13% and the bear market became official. The Dow continued to fall over the next four consecutive days, losing another 14.26% from its pre 9/11 close. All in all, investors were down nearly 30% from January of 2000. With the predictability of a sunrise, trading volume spiked. In fact, the DJIA traded two billion shares for the first time in its history on Sept. 17, 2001. Average daily trading volume increased 50% in the 12 months following the attack as compared to the year prior.

This disaster occurred in the midst of a recession and a declining stock market. As a result, its impact was more acute. However, after bottoming out on Oct. 9, 2002, the markets once again began to ascend. And by the time our next disaster rolled around, the market was well on its way to a complete recovery.

Hurricane Katrina
The two prior disasters were largely unforeseen. However, this particular lady was announced with thunderous pomp, as she sauntered toward the shores of Louisiana. Katrina was one of the deadliest hurricanes in the history of the United States, claiming nearly 2,000 lives, and was the most expensive, sporting a price tag of $45 billion according to the Insurance Institute.

Katrina occurred during a time when the U.S. economy was growing. Even with the infamous title of “Most Expensive Hurricane,” Katrina is virtually undetectable on a stock chart, causing no more than a blip on the screen.

Although it was the most costly hurricane in U.S. history, its financial impact amounted to 0.35% of our nation’s GDP. Considering that the economy was strong at the time, even the oil disruptions were tolerable.

The Great East Japan Earthquake of 2011
On March 11, 2011, just off the east coast of northern Japan, a horrific earthquake measuring 9.0 struck, claiming the lives of more than 15,000 people. This quake was estimated to be over 600 million times more powerful than the Hiroshima bomb. Only two days prior, on March 9, the area experienced four earthquakes in excess of 6.0 with one at 7.2. Following the quake there were more than 800 aftershocks of 4.5 or greater. The tsunamis that followed added an extra layer of grief to the quake and near meltdown of the area’s nuclear power plants. How did the financial markets react?

The DJIA opened at 11,976 and after fluctuating about 1.25% that day, it closed 0.50% higher. Volume on that Friday was just over 3.7 billion shares below its previous 12-month average of 4.4 billion. However, over the next three days, as the disaster continued to unfold, the DJIA registered losses of -0.43%, -1.15% and -2.04%, respectively, on slightly higher volume.

Incidentally, Japan’s major stock index, the Nikkei 225, is down around 7.70% since the day of the earthquake. Volume spiked immediately afterward, but is now back to a normal range.

Let’s turn our focus from disasters and look at the top three all-time worst percentage losses in the Dow. All references reflect DJIA data from Oct. 28, 1928 to present.

October 19, 1987
The largest single-day percentage drop occurred on Oct. 19, 1987. The previous Wednesday, the Dow had lost 3.81%. The following day, Thursday, it was down 2.39% and Friday was no different, losing 4.60%, closing the day at 2,246.73. Not exactly comforting to investors as they headed into the weekend. By the time Monday morning rolled around, few had an appetite for stocks, and by the end of the trading day, the Dow had lost a staggering 22.6%, falling to 1,783.74. Although the cause is still up for debate, there were several potential contributing factors including a falling dollar and rising interest rates. The descent that day began in Hong Kong and spread from time zone to time zone until it reached our shores.

This market decline occurred during the midst of the greatest bull market of the 20th century. Over the next two days, the DJIA logged returns of 5.88% and 10.15%, respectively, recovering much of what it had lost. Amazingly, the market ended on a high note that year, finishing in positive territory. Before 1989 was over, it had eclipsed its 1987 peak, and continued to ascend from there.

October 28 and 29, 1929
The euphoria of the Roaring Twenties was not too dissimilar from the tulip craze of the 1600s. Speculators would borrow from any source possible to invest in that “can’t lose” investment. During the latter stages of a bull cycle, optimism reaches its peak as investors adopt a paradigm where stocks can only rise. Obviously, history belies this illusion.

From its peak of 381.17 on Sept. 3, 1929, the Dow declined 27 of the 40 days leading up to Monday, Oct. 28. From its peak to the Friday before the crash, the Dow had already lost 21% and the “Bad News Bears” were singing, “We’ve Only Just Begun.” That Monday, the DJIA lost an additional 13.47%. The next day it lost 11.73%. That Tuesday was the third worst daily percentage loss. By the time Tuesday’s trading ended, the 21% decline had become 39%.

Even though news didn’t travel as fast back then, it didn’t necessarily need to, as the investment community was more geographically concentrated. Moreover, to help frame the time period, in 1929 there were only 19 open-ended mutual funds as much of the general public had not yet begun to invest.

One final note is in order here. This was the most devastating crash of the 20th century. From the market’s peak on Sept. 3, 1929, it took over 25 years before the 1929 peak was surpassed.

This leads the discussion away from the worst daily losses to the way information is disseminated in today’s society. The chart above illustrates that the first step in the process is when a significant event occurs. The news media is simply a conglomeration of individuals, some with more power than others, but people nonetheless. Suffice it to say that we all have certain biases, so when we are faced with the task of complete and total objectivity, we tend to fall short. Therefore, the event is broadcast with some degree of prejudice. The public is no more immune to this than is the news media. In fact, the public’s perception of a story may be more skewed than that of the media, since it’s the media that provides our information. There is a strong tendency to “follow the crowd.” If we could accurately predict the behavior of investors, then it stands to reason that we could beat them to the punch. However, as more people gained the ability to predict human behavior, the very behavior we were predicting would become that much more unpredictable. In short, though we intuitively understand that it is investors who move markets through the realignment of their capital, we may never achieve the holy grail of investing and therefore completely understand what moves markets.

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