History Shows How the Stock Market Handles a Crisis

We often think we live in unprecedented times. But, the truth is, there is very little that’s never been seen before. Almost every event has a historic precedent and studying those precedents can help us understand how the stock market is likely to react to the current events.

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  • Let’s start with an event that appears to be unique. North Korea is developing a nuclear weapon. Some investors may believe we have never seen anything like this before. But, of course, we have.

    China spent more than a decade pursuing atomic weapons, a pursuit that at the time was every bit as alarming as North Korea’s current pursuit of weapons. China started working with the Soviet Union to develop this capability in 1951, as the Korean War was being fought.

    According to AtomicArchive.com, the Soviet Union withdrew its support in the 1960s but China remained committed to continuing its nuclear weapons development program.

    Experts noted that “China made remarkable progress in the 1960s in developing nuclear weapons. The first Chinese nuclear test was conducted at Lop Nur on October 16, 1964. It was a tower shot involving a fission device with a yield of 25 kilotons. Uranium 235 was used as the nuclear fuel. In less than 32 months, China detonated its first hydrogen bomb on June 14, 1967.”

    The chart below shows how the stock market in the United States reacted to these events.

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  • Traders largely shrugged off the events. This may be surprising given that there was a war in Southeast Asia at the time and there were concerns about China’s military intentions. However, it appears traders focused on the economy during that time. This is usually what we see at times of crisis.

    The Korean War

    The next chart again shows the Dow Jones Industrial Average and highlights important historical events. In this chart, several important dates in the Korean War are highlighted. The initial invasion did spark a selloff but traders seemed to pay little interest to the rest of the war.

    This is not meant to minimize the suffering of the war. The Korean War, and every other armed conflict, results in incredible pain and suffering. Our study is limited to the effect of the conflict on the stock market trading.

    The surprise of the initial invasion in 1950 did spark concerns among traders. Their initial reaction was to sell and the Dow lost nearly 15% in the month after the war began. But, that reaction was rational.

    The Korean War began as the Cold War was in its early days. North Korea was backed by the Soviet Union and China. The United Nations recommended that its member nations provide military assistance to South Korea to stem the Communist advance.

    In this atmosphere, fear was a normal response. But, as it became clear that the United States and its allies would win the war, concerns faded and the stock market rallied.

    Cold War jitters would spark other selloffs over the next decade. The Dow sold off more than 10% when President Eisenhower suffered a heart attack in September 1955 and traders worried about how the country would respond under the leadership of Richard Nixon who was Vice President at that time.

    The failed invasion at the Bay of Pigs in Cuba sparked a decline of 4% in one week in 1961. The next year, the Cuban Missile crisis pushed the Dow down more than 7% in less than two weeks.

    History shows Cold War crises and the shooting war in Korea led to just short term pullbacks in the stock market. These are the type of crises that seem to be most similar to the ongoing crisis in North Korea. But, the stock market has reacted to many other crises.

    Other Crises

    The chart below shows how the stock market has reacted to significant military and geopolitical events in the past. This table uses only end of day data and misses the intraday declines, presenting a more bullish picture of crises. Note how the crisis has generally had only a short term impact on the market.

    From the table above, we can conclude that the state of the economy is more important than the military or geopolitical crisis. This lesson can be illustrated with the three examples from the table that showed a loss in the three months after the date the event began.

    The first loss to consider is the decline after the Soviet Union’s invasion of Afghanistan in December 1979. The National Bureau of Economic Research shows that a recession began in January 1980, the month after this event.

    The US invasion of Panama and the Iraqi invasion of Kuwait began within eight months of each other. NBER data shows that a recession began in July 1990. Some analysts expect the stock market to turn down six to nine months before a recession. These events are within that window.

    Missing from that table is the stock market reaction to the events of 9/11. This terrorist attack led to the stock market being closed for a week as officials rebuilt critical infrastructure. The air transportation system was also shut down after the attack.

    This event had significant economic consequences and has proven to be one of the defining events of the current century, so far.

    NBER data again tells us we were in the midst of a recession at the time of the event. The NBER is the agency responsible for setting the official start and stop dates for the recession. In this case, the recession began in March 2001 and ended in November of that year.

    The attack on 9/11 also came during a bear market. Stocks had peaked in early 2000 as the internet bubble burst. That bear market would continue for more than a year after the attack, ending when major stock market indexes bottomed in October 2002.

    Do Crises Matter to the Stock Market?

    This is, naturally, an incomplete history of the stock market’s reaction to global events. A more comprehensive study would include the World Wars and other armed conflicts. But, the conclusions would be the same.

    In World War II, for example, the stock market was trending down when Pearl Harbor was attacked and the US entered the war. The bottom was reached when news of the Doolittle Raid reached traders. This was a US attack on Japan that demonstrated the US retained a significant offensive capability.

    Stock market gains accelerated after US forces prevailed against Japanese naval forces in the Battle of Midway. By then, it was clear that the US and its allies would eventually triumph.

    The market’s reaction to global crises is usually just a continuation of the dominant trend at the time the event occurs. If we are in a strong bull market, traders seem to ignore the global crisis. If we are in the midst of a bear market or a recession is underway, or about to start, we tend to see prices fall in a crisis.

    That brings us to the question we started with which is how the market will react to current events, especially in Korea. While there is no way to know, if the economy continues to grow, the stock market is likely to move up.

    On the other hand, there are signs the bull market and the economic expansion are nearing an end. If that’s the case, any crisis could result in a major bear market.

    The market’s reaction to news in the coming months will tell us more about the state of the economy than the amount of danger we face. At least that’s been the result in the past.

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