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The Price of Terrorism

September 11 lives on -- in the diminished value of every share of stock that's traded globally.

What's wrong with the stock market? Over the past five years, the economy has been rising on an impressive upward trajectory. Corporate profits have doubled. Inflation has been tame. But the stock market is as flat as a pancake.

No one ever claimed that making money in the stock market was easy, and share prices don't increase precisely in tandem with the economy. The market today could be compensating for its spectacular increase in the 1990s, when Standard Poor's 500-stock index quadrupled as the economy grew about 70%. There's probably some truth to the catch-up theory, but I think something else is at work, and it's worth examining on the fifth anniversary of 9/11. The terrorist attacks in New York City and Washington, D.C., that killed 2,976 people undeniably had a short-term effect on stocks. After trading was suspended for a week, the Dow Jones industrial average reopened at a loss of more than 300 points, then fell nearly another 700 in the next few days.

Legacy of fear

Now it appears that there's a long-term effect as well. The markets fear the worst, and those fears are reflected -- or discounted -- in stock prices. In other words, 9/11 lives on -- in the diminished value of every share of stock that's traded globally.

Of course, I can't prove that the "terror discount" exists, but the signs are unmistakable. If the discount did not exist, then an event like the London subway bombings of July 7, 2005, would have clobbered stock prices, in both Great Britain and the U.S. Instead, two weeks later, the FTSE 100, London's major index, was flat, and the SP 500 was up a few percentage points.


Similarly, the conflict in Lebanon did not hurt stocks. The SP stood at 1272 on July 11, the day before Hezbollah ignited fighting by seizing Israeli soldiers in a cross-border raid, and it closed at 1267 on August 11, the last day of trading before a cease-fire. At least in the short term, the violence would seem to boost the likelihood of global economic distress, yet stocks did not fall. And look what happened on August 10, the day that British authorities foiled a terrorist plot to blow jetliners out of the sky between the U.S. and Britain: The market didn't even blink, trading up 48 points on the Dow at the close.

You might think that after five years without a terrorist attack on U.S. soil, investors might demand a smaller geopolitical discount from stocks. But as Prudential strategist Ed Keon once said, the fear of conflict has historically been worse for stock prices than conflict itself. For example, although the stock market fell in calendar years 1939, 1940 and 1941, as Pearl Harbor approached, the period between the attack and 1945 was the best ever until the 1990s.

Conventional financial risk involves a probability that we can measure through technology or history. It's the chance that a flipped quarter will come up heads, or that U.S. stock prices will produce an average return of 10% annually over long periods. But 20 years before Pearl Harbor, a young economist named Frank Knight conceived the idea that markets have to contend with a kind of uncertainty that "must be taken in a sense radically distinct from the familiar notion of risk."

The unknown

Unlike conventional risk, Knightian uncertainty can't be measured with precision because we lack historic data points. Economist John Maynard Keynes elaborated on the theme in 1937: "The sense in which I am using the term is that in which the prospects of a European war are uncertain. About these matters, there is no scientific basis on which to form any calculable probability whatever. We simply do not know!" Knight's insight was that when people can't reasonably calculate their odds of winning a game, they are reluctant to play. To draw them to the table, the house must increase the payoff, raising the potential return for each bet. That's what is happening in the market today. The price-earnings ratio is low to compensate not for normal equity risk but for unknown geopolitical risk.


But, contrary to Keynes's view, as time passes we have a better grasp of the risk. We learn from observing the world stage, and we make educated guesses. That is the case, I believe, with terrorism -- or, more accurately, with the global war that involves what some people are calling Islamofascism. The shadowy becomes evident, and although a geopolitical discount will always weigh on stocks, it should decline in importance over time -- even if the U.S. does suffer another terrorist attack. In fact, if we truly engage the enemy, as happened in 1942, Knightian uncertainty and the terror discount are likely to dissipate.

Tempting ideas

As a result of low P/Es, the market, in my view, is offering some enticing bargains, and you don't have to go out on a limb to take advantage of them. For example, Value Line Investment Survey's cautious portfolio of 20 so-called stocks for income and potential price appreciation includes some excellent companies. Among them: Eaton Corp. (symbol ETN), industrial parts, at a price-earnings ratio for the next 12 months of 12 and a yield of 2.4%; Fortune Brands (FO), a diversified company that sells wine, golf balls and hardware and has a P/E of 16 and a yield of 2.1%; Johnson Johnson (JNJ), medical supplies, at a P/E of 17 and a yield of 2.3%; Wells Fargo (WFC), banking, at a P/E of 15 and a yield of 3.2%; General Electric (GE), at a P/E of 21 and a yield of 3%.

The Prudent Speculator, one of my favorite newsletters, recommends such growth companies as Bed Bath Beyond (BBBY), Cypress Semiconductor (CY) and Lowe's Cos. (LOW), the home-improvement chain, at a forward P/E of 16. All of these stocks have expected growth rates in double digits for the next five years.

Looking for growth and staying power, I searched for no-load mutual funds with a manager tenure of at least three years, an expense ratio of less than 1%, a Morningstar rating of three stars or higher, annual turnover of no more than 100%, and returns greater than the SP 500 for both 2006 (as of mid August) and for the past ten years.


Only one large-company growth fund and one midsize-company growth fund survived. The large-cap winner is Jensen Portfolio (JENSX), with a turnover rate of just 10%, meaning it typically holds a stock for ten years. The mid-cap winner is Meridian Growth (MERDX), run since its 1984 beginning by Richard Aster Jr. Meridian has returned an annualized 13% the past ten years, beating the SP by almost four percentage points per year, and Jensen nearly a market-matching 10% annualized.

How can I be sure that the terrorism discount will be mitigated at a time of such turmoil and carnage in the Middle East? I can't, but there are precedents. In February 1954, an article in Fortune asked, "Is the Stock Market Obsolete?" The real economy and the markets, the author argued, had parted ways: "The 'nerve center' of capitalism seems to have suffered a partial paralysis since 1946. While U.S. business has been booming, the stock-market 'averages' have risen only a little." Between May 1946, when the post-World War II bull market ended, and March 1953, the gross national product rose more than 75%, according to the article, but shares on the New York Stock Exchange rose less than 25%.

The Cold War effect

Of course, we see now what was happening. While there was joy and relief when World War II ended, uncertainty grew with the nuclear threat from the Soviet Union. But just as Fortune was worrying that stock prices had become detached from economic reality, the market turned around. The SP returned 53% in 1954 and another 32% in 1955 -- the best two back-to-back years since Ibbotson Associates began keeping statistics in 1926. Message: Stay the course.

James K. Glassman is a resident fellow at the American Enterprise Institute, editor of its magazine, The American Enterprise, and host of the Web site Of the stocks mentioned in this article, he owns General Electric.