Market emotion gives way to fundamental decisions

Friday 5th October 2001

The tragic events of September 11 will not be forgotten. Nor will the response of investors that will form the base for many a behavioural finance study in future years.

Over the past three weeks, financial markets have seen the extremes of investor behaviour typically associated with high market volatility. Fear, greed, and panic are emotions often displayed at such times. This is understandable given the sudden, shocking nature of the terrorist attacks but to the objective investor the related market volatility merely opens up a field of new opportunity as other investors act based on their heart rather than mind.

Markets around the world fell 10-15% immediately after the attacks. Our analyses of past global crises show that market correlations move up close to one in such periods. In lay terms this says investors act as one in such times and do not discriminate between the affected and non-affected countries. This clearly doesn't make sense but the adage "markets hate uncertainty" tends to rule in such circumstance.

Pushing through the mists of emotion are firms such as Alliance Bernstein, a New York-based investment-
management firm noted for its deep- value investing style. Just two days after evacuating its offices as a safety precaution it was communicating to clients macro and industry analyses. One can reasonably deduce such firms would be ready and waiting once the markets reopened to seize the opportunities created where other investors acted irrationally or were forced to sell for other reasons.

In the past week we have started to see a more orderly pattern of discrimination between markets and the industry groups within each. Travel, tourism and related business were, as happened in 1990, likely initial casualties. It was also perceived the fire and general insurance industry would be a major loser, though if this is a one-off then the industry's fundamentals may in fact be enhanced over the medium term. In contrast, security, defence and healthcare could be seen to be fortuitous winners from the attacks. Stock prices in these industries logically have moved to differing degrees.

The terrorism has come at a time when the US economy was slowing and potentially falling into recession. As with 11 years ago, the unexpected negative news will tip the US economy into recession. Many companies were already being priced on a reasonable likelihood of recession - that is now considered a certainty for the second half of 2001.

While some of the market declines have occurred through irrational investor behaviour, as investment professionals wrest control of financial markets back to fundamentals we will see a more discerning pattern of stock and market movements.

The downdraft of company earnings declines for the four quarters may periodically push the equity markets lower. However, the massive fiscal and monetary stimulus being applied in the US and around the world will have an impact. This is also a clear point of distinction from 1990, when monetary and fiscal policy (US taxes were actually rising) was overly tight.

Energy prices are also in decline, a contrast to 1990, and that will also provide stimulus.

Economic forecasters are uncertain when the combined stimuli will feed through and counteract contractionary forces. But one can be certain of reasonable economic growth conditions again prevailing (irrespective of the desires of terrorists).

A last note. Another poke in the Kiwi business psyche by the Aussies. Our observation is that on average the Australian funds-management industry reacted to the US attacks in a more deliberate and constructive way than those New Zealand-based fund managers who on September 12 immediately shut the doors on all their funds - whether or not they held US securities.

However, it should also be noted, at the other end of the scale among domestic funds managers, locally owned NZ Funds Management managed to price and keep open all its funds for both new investments and redemptions during the crisis. The lesson for fund managers: if you manage an open-end fund, keep it open whenever possible.

David van Schaardenburg is executive chairman of FundSource, the investment strategy and funds management research company

Disclosure: Fundsource acts as consultant in asset allocation strategy and fund manager selection to NZ Funds and its clients

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