Terrorism Hurts Markets, but How Much?

How much does terrorism affect stock prices?

To find the answer, economists have parsed market reaction to events dating back to the 1915 sinking of the Lusitania, academics have studied how attacks on McDonald's restaurants have affected the company's stock price and researchers in Israel have chronicled what 13 years of suicide bombings did to stocks there.

Their unsurprising general conclusion is that terror attacks hurt stock prices, but some of the details are unexpected. For instance, after Sept. 11, 2001, the stocks in the Standard & Poor's 500 rebounded to their pre-attack prices faster than every other major world index except Japan's Nikkei, according to research by Andrew H. Chen of Southern Methodist University and Thomas F. Siems of the Federal Reserve Bank of Dallas.

What none of the research has answered is the degree to which the fear of another terrorist attack on the United States has been factored into stock prices.

David Sowerby, chief market analyst, Loomis, Sayles & Co., estimates that the threat of terrorism represents a 5 percent tether on stocks. How did he get that number?

The overhang is more than zero, less than 10. Five seems reasonable. If I said 4, I'd be fine-tuning it too much, he said.

The price-to-earnings ratio on the S&P 500 is around 17. A traditional model pegs the price-to-earnings ratio, one of the most popular methods of gauging a stock's value, to Treasury bond yields. Under that formula, the price-to-earnings ratio should be closer to 20, said David Wyss, chief economist for Standard & Poor's.

What's holding prices back? Is it terrorist attacks, distrust of earnings, expectations of a slowdown? he said. I don't know.

Similarly, people keep saying there's a war premium in the price of oil, said Robert Streed, portfolio manager of Northern Trust Selec t Equity Fund in Chicago. People keep throwing out numbers, but I can't see any objective way they come up with those numbers.

Those who say some threat of a future attack is already baked into stock prices hasten to add that another attack in the United States would still send prices lower.

We would likely see a drop in stock prices of significant proportion, but investors seem to believe there would be a subsequent recovery, said Lynn Reaser, chief economist at the investment strategies group of Bank of America. As an important footnote, the scope and the magnitude and the form of a terrorist attack would determine whether or not that assessment is correct.

If the extent to which terrorism has pressured stocks is an academic question, as Streed says, it is one academics have shown little interest in. Instead, they've focused their studies on how markets responded to past terrorist attacks.

Chen and Siems tracked the Dow Jones industrial average's recovery time from events ranging from the torpedo of the passenger ship Lusitania by Germany during World War I to Hitler's invasion of France to Sept. 11. They found that while the Dow rose the day of the Oklahoma City bombing and the bombing of the U.S. embassy in Kenya, it took the index 795 trading days to recover from the invasion of France and 232 days to rebound from the attack on Pearl Harbor. They theorize that faster communication and broader market participation has led to faster stock rebounds.

A study by Israeli academics of stocks and suicide bombings found that stocks in companies outside the defense sector fell 4.58 percent.

And large-scale attacks aren't the only way terrorism affects stocks. Seventy-five attacks between 1998 and 2003 targeted businesses, according to G. Andrew Karolyi, a professor of finance at Ohio State University and Rodolfo Martell, an assistant professor of finance at Purdue University. The most frequent target was McDonald's Corp., which was attacked 10 times, including the ransacking of a half-built restaurant in France and a deadly firebombing in Indonesia. Stock in the attacked companies had a one-day decline of 0.83 percent for an average loss of $401 million, they found. Ten days later, the stocks had not recovered.

What no one seems to talk about when it comes to terrorism is the possibility of a market crash. That may be because a spate of attacks worldwide, from Madrid to Mumbai, has not caused any country's market to crash.

As former Securities and Exchange Commission Chairman Harvey L. Pitt testified before the House Committee on Financial Services on Sept. 26, 2001. The markets did not give way to panic selling.They simply did what they do best: They assessed, and responded to, the crisis rationally. Unlike human beings, capital markets are capable of absorbing great shocks quickly.