Does crisis and war create a buying Opportunity?

They correctly point to Pearl Harbor, the Cuban Missile crisis, the J.F.K. assassination, the 1973 oil embargo, the Nixon resignation, the 1987 stock market crash, the Gulf War ultimatum and the LTCM crisis, and so on. Here you would already have made money after a six to 12 months holding period.

In particular Pearl Harbor has been widely mentioned as an example that a military setback or a war provides a great entry point into equities. However, I should just like to highlight some key differences between Pearl Harbor in 1941 and the September 11, 2001 attacks.

When the American Fleet was attacked at Pearl Harbor on December 6, 1941, the US stock market was at one of its most, if not the most depressed level in the 20 century. The American stock market capitalization as a percentage of GDP amounted to just 21% - an all time record low - compared to presently approximately 120% (down from 184% in March 2000).

Shortly before the attack on Pearl Harbor, the Dow Jones sold around 115 (the 1941 trading range for the Dow Jones was 133.6 to 106.3). The Dow was down from a high of 381.1 in 1929 and 194.4 in 1937. In other words, the Dow was 12 years after its 1929 high still down by 70%. Over the same period of time, the Dow Jones' earnings per share had fallen to $11.6 down from a high of $19.9 in 1929.

Moreover, at its December 1941 low the Dow Jones sold for less than its book value and it had a dividend yield of 6.2%, and a P/E ratio of 10.5 on depressed earnings. Then let us briefly look at the earnings yield bond yield ratio and the dividend bond yield ratio, both indicators, which are now widely used by strategists to foster their bullish case.

In 1941, long-term government bonds yielded between a low of 1.85% and a high of 2.10%. Prime corporate bond yields averaged 2.56%. Thus, the Dow Jones had a dividend yield of more than three times the yield of long-term government bonds. Also, after the attack on Pearl Harbor the Dow Jones' earnings yield reached more than 10% - that was more than 5 times higher than the long-term government bond yields!

By comparison, at present, long-term government bonds yield three times more than the S&P 500 dividend yield and also exceed its earnings yield, possibly by far more than strategists seem to think, if earnings do not recover!

Thus, I feel that the comparison between Pearl Harbor in 1941 and the September 11, 2001 attack is rather far fetched. In fact if we compare bond yields and dividend yields of the stock market in the US since 1871, we note that the maximum gap of stocks yielding more than bonds was reached in 1941, whereas a maximum gap of bonds yielding more than equities was reached in 2000.

The 1940s represented from a longer-term perspective the very best buying opportunity for US stocks. This was so, because growth expectations were extremely low, which explains why investors had a preference for the safety of much lower bond yields over the 'uncertain' dividends paid out by equities.

The mirror image, however, occurred in 2000. Never before was the gap between bond yield and dividend yield wider, indicating 'euphoric' expectations by investors about future economic and corporate profit growth. Thus, the way the 1941 provided a lifetime buying opportunity for US stocks, future financial history books may regard the years 2000/2001 as having provided a lifetime opportunity to liquidate US equities.

If any comparison ought to be made between 1941 and 2001, it ought to relate to the US bond market. In 1941, US bond yields touched a historical low. In other words, never before 1941 and never since have bond yields in the US been lower than in that year. So, whereas the 1940s provided a great entry point into the US stock market, it also provided a lifetime selling opportunity for US bonds, since following their lows in 1941, government bond yields subsequently rose to 7% in 1975 and 15% in 1981.

Could it be that 2001 will also mark a secular low for US interest rates? Quite possible, especially after the recent strong rise following the announcement that the Treasury would stop selling 30 years Treasury bonds. Interest rates have been declining since 1981and are unlikely to decline much more, given the stimulus packages, which will turn the budget surplus into a deficit.

Moreover, longer lasting wars are inflationary and usually lead to a pick up in commodity prices and interest rates. Finally, anybody who isn't brain damaged must ask himself why the Treasury did not stop selling 30 years bonds in 1981, when interest rates reached 15% on long term government securities. Why wait until interest rates are approaching a major low?!

In my opinion, now that rates are low the Treasury should be interested to issue as many long term securities as possible, while when interest rates are high, as they were in the 1980s, the budgetary needs should be financed with short maturities.

In any event, investors must remember that in 1941, there was a big winner and a big loser among the investment community. Stock buyers did well as the market rose rapidly in the 1950s and 1960s. Conversely, bond-holders, lost out as the bond market remained in a long-term bear market for the next 40 years!

Who the big winners and losers of 2001 will be remains for financial history to tell us, but I doubt that both equity and bond holders will perform well. Moreover, it is possible that 'this time' will be indeed different and that both equity and bond holders will perform badly.

There is one more point to consider. While in the 1940s the purchase of US equities provided subsequently high returns - at least until the end of the 1960s, superior returns were achieved in Japan between the end of the Second World War and 1989. Equally German and Continental European stocks performed better than the US stock market between the end of the War and their peak in 1961/62 (after that they traded in a range until 1986, before resuming their up-trend).

Conversely, it would have been wrong to buy Egyptian shares (before the Second World War, the Cairo Stock Exchange was the world's fourth most active market), Shanghai shares and all Eastern European Bourses. All these markets became worthless at the end of the 1940s or in the early 1950s, as a result of expropriation.

And while it was a good time to buy US equities during the Gulf War in 1990, the same, cannot be said about the purchase of Japanese, Taiwanese, and South Korean stocks in 1990. Having then been over-valued, they are all, today- 11 years later - still down in dollar terms by around 70% from their 1989/1990 highs.
Thus, whether a crisis provides investors with an, in the long run, rewarding buying opportunity, depends largely on the, at the time of the crisis prevailing valuation and future economic and financial developments.

Compared to other markets around the world, the US stock market, whose total capitalization still amounts to around 120% of GDP (compared to only 40% at the onset of the Gulf War and as mentioned above 21% in 1941), is still richly priced.

Therefore, in the event of a favorable resolution of the current conflict and of renewed economic growth next year, the now inexpensively priced Asian markets may offer the best up-side potential.