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Considering the Effects of September 11 on Your Finances

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By John Vineyard

The terrorist attacks on New York and Washington triggered the worst week for equities since 1933. What would cause reasonably sane investment managers to go into panic mode and dump so much stock? The most glaring reason is that the markets were forced to suddenly shift perspective -- from the expectation of a brief recession to the possibility of a major war and a worldwide recession.

There have been only a few other instances in the past century when market perception was so drastically and rapidly revised. The fall of France in 1940, the attack on Pearl Harbor, and the Cuban missile crisis in 1962 may be of similar magnitude, but it would be a mistake to use those events to interpret the present. This is not the Persian Gulf war. It's not the British Afghan disasters of the 19th century, the Russians in Afghanistan, or the crash of 1929. It's where we are right now.

The economy, which was just beginning to show signs of strengthening in August, has clearly been hit. The financial losses of the first two weeks after the attacks will mostly be recovered eventually; but new costs have been added in addition to the terrible personal costs of the atrocities themselves. These weigh most heavily on the travel sector, because of a lower pattern of travel and much higher security-related costs. Layoffs in the airline and aircraft industries are probably coming too fast for the economy to absorb all those laid-off workers, so higher unemployment will result as the impact of each layoff ripples into related sectors.

Many of these dislocations recycle into different economic activity rather than lost activity, but some of them depress productivity because spending money on beefed-up security is less productive than some of the uses to which the same dollars might have been put in the absence of the terrorist threat. Although what happened will probably tip the economy over a narrow line that now meets the official definition of recession -- namely two consecutive quarters of negative growth -- the additional costs are not severe, and they are light indeed compared with the costs of taking no action and just waiting for the next terrorist attacks. Upheavals also create major new opportunities. So the weeks ahead will display a good deal of effort among some investors trying to decide who the beneficiaries will be, as well as those who have been hurt.

The major reason for the rapid drop in stock values is the spreading fear of the broad economic consequences. But subtle factors are at work as well: Big investment managers tend to focus intensely on short-term investment performance. Many of today's fund managers are too young to remember the last bad recession in 1990-91. And last month's attacks came right on top of the burst technology bubble -- maybe at the worst possible moment.

Our "normal" yardsticks of stock valuation are suddenly out of date and perhaps useless. The range of possibilities appears to have suddenly widened. (In fact, "normal" times are perilous too, but we tend to ignore the real dangers in normal times and suddenly magnify them at times like this.) The terrorist forces have been at work for years, striking U.S. interests again and again, and each time we've put it into the back of our minds as quickly as possible. The essential strengths of the economy have remained.

The new downside is distinctly worse than the scenarios we had previously been using to estimate the range of possible futures. A long, costly war that failed to stem terrorists and stirred up civil wars abroad and dissent among our allies would be grim indeed. Government spending to support a protracted war might trigger a renewal of inflation. In addition to the costs of future terrorist attacks, the added dissent and domestic disunion that would flow from that might produce a scenario like the 1970s, where stocks and bonds both suffered from inflation and national self-confidence plummeted.

To balance the picture, we have to consider some of the positive indicators. As the Federal Reserve Board has lowered interest rates all year and continues to do so, it has provided a massive stimulus that will eventually kick in. Everyone who owes money, especially home mortgage holders, essentially is being given a substantial raise. The costs of borrowing are sharply lower for business as well. Recent cuts in travel mean that the cost of energy is going to be sharply lower than expected. Business inventories have already been through an extended period of reduction, and business has been forced to become leaner and meaner by the past year's downturn.

Huge and unanticipated government expenditures in the wake of the attacks are coming. This is traditionally considered the correct medicine for treating recession. Experience with rebuilding after natural disasters shows that this can provide a powerful stimulus. Finally, corporate capital spending, having been sharply reduced for a year, will have to rebound at some point. If the terrorist threat can be shown to be contained somewhat, the ingredients may be in place for a surprising recovery.

With this new range of uncertainties, we as investors should re-emphasize some basic principles and add a few twists to accommodate the current situation. Some professors will find, when they look at their latest investment statements, that they no longer have as much as they thought they would need in order to retire, and they may delay the decision to leave academe. Some will decide to retire anyway, figuring that a retirement fund is something used over many years that will see normal growth again at some point. Some academics already in retirement will see their income from fixed investments begin to decline as interest rates fall. This may bring some back to the workplace in various ways. The recent events underline why it is important to move beyond the traditional concept of retirement as a date to which you aim all of your working life and after which you coast.

The idea of a broad diversification of investments remains sound. Note that at some point there will be unexpected good news, and after such a down period, the rebound, however temporary, could be dramatic. So it will be possible for some to be drawn into the turbulence, and under such conditions it is quite possible to lose more than the amount that the overall market declines. More than ever, yesterday's hot sector can be tomorrow's quagmire. Broad diversification allows you to stay out of the pitfalls along your path.

Given an expected recession, what kinds of investments are likely to do the best and the worst? Typical defensive stocks include food, alcohol, tobacco, defense, health care, gold, and some natural resources. Saving money is the premier defensive play, followed by short-term bonds, intermediate bonds, and then long-term bonds. It's probably still too early to own much in information technology, except in special sectors or industries with a strong military component. Note, however, that each of those could quickly change in attractiveness. For those with longer horizons, redeploying everything into defensive sectors now may not be worth doing.

However events turn out, many investors are likely to emerge with a new caution regarding the time horizon of equity investments -- i.e. how long before you need the money. The commonplace advice used to be that any money you need within five years should be placed in lower-risk investments, such as treasury bonds. Now perhaps a 10-year horizon makes more sense for those in retirement or close to it.

For those with longer periods until retirement, it makes sense to continue more or less unchanged, provided the allocation of holdings and contributions was prudent before September 11. If you still have many years of accumulation ahead, the ideal path for markets to take would actually be to poke along for many years, and then grow strongly later on. This might seem illogical at first, but it works because your regular retirement contribution buys more shares when the market is depressed. If you still have many years of contributions ahead, the actual shape of future market growth can make a huge difference in your ultimate wealth. It would almost certainly be a mistake to allow the current recession to cause you to move everything to cash.

Current events really don't tell us anything about where the markets will be in 20 years. Maybe not even 20 days.