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War Is Hell on Markets, Too

By Amey Stone When it comes to news that can spark a stock market rally, Apr. 8 was about as good as it gets. Positive first-quarter earnings reports were pouring in. Yahoo! (YHOO) said the online advertising market was plumping up far better than expected (see BW Online, 4/8/04, For Yahoo, Earnings to Yodel About). General Electric (GE), Federal Express (FDX), and Dell Computer (DELL) all raised their 2004 forecasts.

Strong economic tidings emerged that morning as well. Same-store retail sales were robust, and first-time jobless claims were at their lowest level since 2001. Moody's Investors service saw evidence of a new "virtuous cycle where an above-trend rate of growth for consumer spending compels businesses to add employees which, in turn, stokes personal income growth."

SORRY FACT OF LIFE. So why did the S&P 500-stock index and Nasdaq composite end the day flat and the Dow Jones industrial average drop 38 points? Fighting was intensifying in Iraq. And all eyes were on National Security Adviser Condoleezza Rice in her first testimony before the September 11 commission investigating the events leading up to the terrorist attacks.

"Everything went right [on Apr. 8], but people aren't talking about it," observed Peter Coolidge, a portfolio manager at Deltec Asset Management in New York. "They're talking about Iraq, and it's putting the market in a funk."

It has almost become a fact of life in the early 21st century: Post-September 11 concerns about war in the Middle East and the nation's security seem to perpetually hang over the markets and the economy, sometimes putting a drag on even the most promising economic news. "The economy is booming, the jobs report was just terrific, and earnings season is just going to be great," said Donald Luskin, chief investment officer of research boutique TrendMacrolytics on Apr. 8. "If it weren't for Iraq, we probably could have had a 200-point up day."

GUT-WRENCHING REMINDER. Stocks were down sharply for much the same reason on Apr. 7, says Trip Jones, managing director in strategy and sales at SunGard Institutional Brokerage. That day he met with managers of a "very large" hedge fund. "Just about all they wanted to talk about was geopolitics," he says. Although some commentators pointed to weak earnings news from Seagate Technology (STX) and Alcoa (AA) as the cause of that day's downturn, "we felt it was Iraq violence driving the market down," he says.

Since when do national-security issues trump strong corporate earnings and rebounding U.S. economic growth on Wall Street? Almost always in times of war, for one. Markets have a history of being flat during periods of peril, going back to World War I. And the escalation in fighting and surge in casualties in Iraq has been a gut-wrenching reminder that war is what the U.S. is embroiled in.

"How does that affect corporate profits? Not directly," admits Coolidge. "But it could have an impact to the extent that people start to worry about the conflict spreading and the U.S getting bogged down."

DAMPENED SPIRITS. Investors are worrying about the potential for a coordinated Shiite and Sunni uprising (see BW Online, 4/7/04, "Iraq: Rising Radicalism, Falling Hopes"). They also fear the war could escalate into a regional conflict, with the U.S. pitted against Syria or Iran as well Iraq, Brian Williamson, an equity trader at Boston Co., explained to clients in an Apr. 7 note.

More broadly, renewed fears of terrorism are acting as a drag on consumer and business confidence. The prospect of more acts of savagery has put a damper on investors' spirits ever since the March bombing of Madrid's commuter rails. Al Qaeda apparently trying out new tactics for disrupting the unity of coalition forces is a recent threat, says Jones.

At the same time, ongoing questions about Washington's opportunity to prevent the September 11 attacks seem to be changing the national psychology about that tragedy. "It used to be a source of unity and defiance," Luskin says. "Now it's all about weakness and fear. That's not good."

"BAD TWICE." If this weren't an election year, investors' focus on geopolitical events wouldn't be so sharp, strategists say. But with so much uncertainty, the markets tend to react favorably to news that would help the incumbent President Bush, many analysts say. It's not just his emphasis on tax cuts and a probusiness agenda, they believe. As much as the surprisingly strong March payrolls number played in his favor (sparking a stock market rally), the growing insurgency in Iraq and mounting questions about September 11 damages his reelection prospects and increase uncertainty in a new Administration, they point out.

Futures contracts pegged to Bush's reelection chances on the Web site have been a reliable leading indicator for Nasdaq's direction, says Luskin. He decided to sell stocks after the opening bell on Apr. 8 partly because he saw Bush's reelection probabilities falling from about 65% after the payroll report, to 58% as street violence spread in Iraq and the September 11 commission pressed Bush officials harder for pre-attack preparedness information.

"A factor can be bad twice," he says, referring to Iraq. "It's bad in and of itself. Separately, it could cost George Bush the election, which would be a disaster for stocks."

JULY 1 FANTASY. The timing ahead of the long Easter holiday weekend also added to investors' skittishness. "Traders want to go home flat and don't want to take a chance of terrorism or the war getting out of hand," says Jones. "If nothing happens, they buy on Monday." Coolidge points out that on low-volume days proceeding major holidays, market swings are often exaggerated.

The recent market sluggishness may ultimately prove a buying opportunity. "When I think about the events leading up to the Gulf War, there was a lot of fear and concern in the markets that in retrospect didn't make a heck of a lot of sense," says Lincoln Anderson, chief investment officer at brokerage LPL Financial Services. "That was the bottom, and then it was off to the races after that."

Still, the idea of the U.S. turning over control of Iraq to the Iraqis on July 1, as President Bush vows to do, increasingly looks like a fantasy. It will probably take many months, perhaps years, for coalition forces in Iraq to put down the violence that has created so much nervousness among investors. And the looming turnover date will likely add to the uncertainty for the next few months. That's something for investors to be mindful of, even as strong earnings reports and improving economic news continue to roll in. Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

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