Money: Counting the Cost

By MARK FRYER

If there were still any doubts that the world is now one big investment market, they should have been erased by the events of September 11.

The terrorists who attacked New York and Washington may have targeted one of the icons of United States capitalism, but the financial fallout hit markets all over the world.

When US share prices plunged, so did shares in Europe, Japan, the rest of Asia, Australia and New Zealand.

So how bad has the damage been, and what lies ahead?

Second questions first; no one knows what lies ahead. Not George W. Bush, not the terrorists, not the most learned sharemarket analysts.

All that is clear is that investment markets are likely to remain turbulent.

What to do? Nothing at all might not be such a bad strategy until the picture clears.

In the meantime, here's the story so far.

How bad was the damage?

In short, about as bad as it gets.

Precisely how bad depends on what measuring stick you use. If you're a follower of the Dow-Jones index, US share prices suffered their biggest one-week fall since 1933 - down more than 14 per cent in the week ending September 21.

As measured by the S&P500 index - a more accurate gauge than the Dow - US share prices were down 11.6 per cent that week, the biggest weekly drop since 1987.

The damage rubbed off on markets all over the world, as the graphs above show.

Don't be too smug if you don't own any shares directly; the vast majority of superannuation schemes will have been hit by falling share prices, as will "balanced" or "diversified" managed funds.

Does history tell what happens next?

Ever since September 11, some market-watchers have been combing the archives to see how sharemarkets responded to past incidents which pitched the US into war.

The general conclusion: war is good for sharemarkets, or at least it is for the US sharemarket.

According to investment website Markethistory.com, the sharemarket typically fell in the first month after the initial incident, but rallied strongly over the next 12 to 18 months.

But it might be wise to take history's lessons with a large grain of salt. Unlike past incidents, the latest attacks were on American soil, media coverage was unprecedented and the enemy is unclear, as is the shape of any military reaction.

And even before the attacks, most of the developed world's economies already appeared to be heading into a recession.

In short, what happened in the past matters less than what happens next.

In that regard, one gloomy signal is the sharp fall in US consumer sentiment, as revealed in figures released this week.

The latest figures, based on surveys taken both before and after September 11, showed consumer confidence suffered its largest one-month drop for almost 11 years, making recession in the US more likely.

Is there any good news?

There are a few glimmers amid the gloom, depending on your point of view.

Interest rates are down - bad news if you get your income from bank deposits, but a welcome break for homeowners.

The rate cuts should also provide a boost - eventually - for sharemarkets.

Lower interest rates are also good news for anyone with money in the fixed-interest market, or in managed funds which hold a portion of their investments in fixed-interest, as super schemes and "balanced" funds invariably do. That's because when interest rates are falling, the value of existing fixed-interest investments rises, providing investors with a capital gain.

For anyone with investments overseas, the fall in the kiwi dollar since the attacks has also been a plus, reducing the loss those investments would otherwise have suffered.

So is it time to sell shares?

Selling might be a natural reaction, but it wouldn't necessarily be a sensible one.

The value of owning shares depends not on what has already happened to sharemarkets but on what happens next.

Since no one knows the answer to that question, the case for shares is much the same as it was before September 11; if you want long-term growth, and are prepared to suffer some falls, they're an essential part of an investment portfolio.

Aon Consulting, which advises many superannuation schemes, looked at whether they should respond to the attacks on the US by cutting their share investments and switching to bonds or bank deposits. However, it found no reason to assume such investments would outperform shares in the near future.

Selling shares at this stage, Aon points out, will turn paper losses into real ones, while passing up the chance to share in any recovery in share prices.

Is anyone shouting 'buy'?

Quite a few people.

For example, managed fund researcher Morningstar convened a panel of investment experts, who decided there was now a strong argument for shares in preference to other supposedly "safer" investments over the next 12 months.

On Wall St, Goldman, Sachs and Banc of America Securities this week urged investors to boost the percentage of US stocks in their portfolios, arguing that lower share prices already reflect the expected plunge in corporate profits.

While such statements should be treated with a certain cynicism, given the analysts' vested interest in keeping the market rolling, there are some reasons to regard US shares as relatively cheap.

One way of valuing a company's shares is to compare their price with the company's expected earnings. The shares in the S&P 500 index now sell for about 21 times this year's expected earnings, their lowest for more than four years.

Another popular way of valuing shares compares the expected earnings on shares with the return on US Government stock, and indicates that US shares are now undervalued by about 16 per cent.

The danger is that earnings forecasts used in those calculations may prove optimistic if the US recession is worse than expected.

What to do?

At times like this it's easier to say what not to do:

* Give up on shares altogether. Yes, you'll avoid any further falls, but you'll miss out on any future recovery too.

* Buy shares just because they're "cheap". They may be less expensive than they were, but there's no guarantee that they won't go lower.

* Sell shares now and get back in when the markets pick up. Chances are you won't know when that is until after it's happened.

If that sounds contradictory, you're not alone: Aon came to the conclusion that there just isn't enough information yet to justify changing investment strategies.

In the words of John Brennan, chairman of Vanguard, a large US fund manager, "If your investment goals are long-term, reacting to short-term events or trends - even momentous ones - is usually a mistake."

* Contact Personal Finance Editor Mark Fryer at: Business Herald, PO Box 32, Auckland. Phone: (09) 373-6400 ext 8833. Fax: (09) 373-6423. e-mail: mark_fryer@herald.co.nz.