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Should History Be My Guide To The Markets?

By Ali Jaffery

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Many investors struggle to understand the direction of the current stock market by examining its history. But does the past offer any clues?
Not in years has there been such interest in the stock market's past.Since Sept. 11, business pundits, like gossip columnists dredging up a troubled starlet's past indelicacies, have rushed to recount the stock market's short- and long-term reactions to every previous instance of economic distress, foreign war or domestic violence.
Apprehensive investors, reeling from events of the past year, have hung on every word, hungry for any indication of where the market might head next.
So does the past offer any clues? Yes, but beware: Making such connections is a subtle art riddled with pitfalls.
What, for example, should one make of the fact that those who fled stocks during the Great Depression avoided a downturn of more than two decades, but that those who chose the same route after the 1987 crash missed out on a fairly quick recovery? The Dow Jones Industrial Average didn't return to its 1929 peak for 25 years, but took only 22 months to regain what it had lost in the 1987 crash.
History is a guide, but you can't just use it blindly.

General Lessons
Investors would do best to look to the stock market's history for general lessons, rather than consider it a specific road map. As Mark Twain said, "History doesn't repeat itself, but it sure does rhyme."
For starters, investors might take heart in the lesson that stock-market history demonstrates most clearly: The market possesses an amazing resilience.
To some degree, markets always react the same to "sudden thunderbolts," such as the Sept. 11 terrorist attacks. They tank immediately, and then they go back to doing what they do, which is looking for value.
The market's behavior in the wake of the Sept. 11 tragedy has been no exception. When the stock market reopened on Sept. 17, the Dow plunged 684.81 points, or 7.1%. It proceeded on to its worst weekly loss since 1933, hitting a low of 8235.81 on Sept. 21. But since then, the Dow has climbed about 20%.
Market history is replete with similar examples of stocks falling in the immediate aftermath of a shock -- and then recovering fairly quickly.
The Dow plummeted and oil prices spiked when Iraq invaded Kuwait in 1990. But the market bounced back and oil prices fell in 1991 with Iraq's defeat in the Gulf War.
Like the Sept. 11 attacks, both the 1962 Cuban Missile Crisis and the assassination of President John F. Kennedy in 1963 were huge shocks that induced massive uncertainty into the way people went about their lives. Yet both had little impact on the stock market.
The Dow, for instance, fell 1.9% on the first trading day after President Kennedy told the American people that there was evidence that the Soviets were building missile sites in Cuba. The president ordered a naval blockade around Cuba and warned the Soviets that any nuclear missile launched from Cuba against any nation in the Western Hemisphere would require an attack against the Soviet Union. Just four months later, the Dow was up 21.3%.
The Dow fell 2.9% on the first trading day after the Kennedy assassination, but was up 12.4% two months later. Again, reassurance played a role.
On Dec. 8, 1941, the day after the Japanese attack on Pearl Harbor, the Dow fell 3.5%. The market bottomed in April 1942, the same month a squadron of American bombers conducted a raid on Tokyo -- a big boost to American morale. And the Dow was nearly even a year later.
The market recovered even more quickly during the Korean War as concerns about communist control of the southern half of Korea dissipated. The Dow lost 4.7% on the first trading day after the North Korean army crossed the 38th parallel to attack South Korea, but one month later, the Dow was up 2.4%.
It's still unclear what the long-term impact of the Sept. 11 attacks and the war in Afghanistan will be.
The biggest impact is likely to come not from the war itself but from the economic fallout of the attacks. The travel industry has certainly been hurt. Lots of things that used to occur now occur in different ways than they did before. That's likely to be a longer-term change in the way people behave, and that probably imposes real costs, and those costs are going to shake out in various ways and probably have some implications for at least some industries or firms, too.

Not Your Historical Market
Investors using market history as an indicator also must consider that what once held true may no longer be relevant as the market changes over many years.

The difference in the length of time it took the market to recover after the 1929 and 1987 crashes clearly illustrates that the cycle of decline and recovery has accelerated.
That is partly due to increased stock-market participation. Fewer than about 2% of the population held stocks in 1929, and after the crash, they got spooked. Now, stocks are a key part of mainstream investing -- about half of households participate in the stock market either directly or through mutual funds -- and are widely considered the best long-term investment. Although short-term volatility may be greater due to day traders and others seeking quick gains, long-term swings are much more moderate.
And investors must consider differences in economic policy and the nation's mood when considering how relevant the market's past response is today.

For example, the market was only part of the story in 1929. The Depression began in August 1929 when the economy began to sink. Economic policy did almost everything wrong that it could. In late 1929 and into the 1930s, the Federal Reserve actually tightened monetary policy and raised interest rates, instead of lowering interest rates to try to stimulate the economy as it did this past year.
And in the wake of the Sept. 11 attacks, the Federal Reserve acted quickly to provide emergency loans to major U.S. banks and offered an arrangement for standby credit to central banks in other nations to facilitate the exchange of currency.
In the end, the fundamentals of earnings and the economy do prevail over the other page-one news, but not without some turmoil in the market. This time around, the key issue is the U.S. economy in 2002 and the following years.

History in the Markets

How the Dow Jones Industrial Average fared in the wake of these events

Event Date Day First trading day 6 months later One year later
USS Maine explodes 2/15/1898 Tuesday -2.1% 14.9% 24.9%
Lusitania sinks 5/7/1915 Friday -4.5 36.0 32.7
Pearl Harbor 12/7/1941 Sunday -3.5 -9.5 -1.4
Korean War 6/25/1950 Sunday -4.7 2.4 9.3
Sputnik launched 10/4/1957 Friday -2.0 -4.6 15.6
Cuban Missile Crisis 10/22/1962 Monday -1.9 25.1 31.4
Kennedy assassination 11/22/1963 Friday -2.9 12.0 21.6
Tonkin Gulf attack 8/4/1964 Tuesday -0.9 7.6 5.2
Nixon resigns 8/8/1974 Thursday -1.6 -10.7 2.5
Iran hostage crisis 11/4/1979 Sunday -0.8 -0.3 14.4
Kuwait invasion 8/2/1990 Thursday -1.2 -5.8 3.7
WTC bombing 2/26/1993 Friday 0.2 8.4 14.1
Terrorist attacks 9/11/2001 Tuesday -7.1 - -

Source: Dow Jones Indexes

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