As a matter of investment strategy, how important is the question of war or peace? Is war, especially a small and distant war, best viewed as part of the random background noise ever present in security markets? Or is it a significant factor in determining market prices? Does history document the existence of a war risk premium that depresses stock prices, and if so how large?
In short, I find evidence of a war risk premium. It seeps into prices as the market perceives the likelihood of war, lowering the price of stocks, and it leaves as the market's uncertainty about the conflict dissipates, raising the price of stocks. But its importance to investment decision-making is modest in relation to fundamental economic factors such as volatility, inflation and earnings growth. By contrast, the short-term war premium is a mere distraction.
History clearly records war as a normal state of human affairs. From the perspective of a U.S. investor, the past 100 years included five significant periods of war: World War I, World War II, the Korean War, the Vietnam War and the Gulf War.
To test whether these periods of war are associated with an elevated equity risk premium, I statistically examined the market's earnings yield, that is, the earnings/price ratio, over the past 100 years. The earnings yield provides a measure of the market's future return including any risk premium for war. If a war premium exists, then the market's earnings yield should be higher during periods of war - after accounting for the effects of fundamental variables including volatility, inflation and earnings growth. While I find a statistically significant war risk premium of 0.9%, the economic significance of this premium should be viewed in context of long-term trends in the market's earnings yield.
From 1903 through year-end 2002, there has been wide variation in the market's earnings yield (measured as the 10-year average of real earnings for the Standard & Poor's 500 divided by the next month's price). It briefly peaked at 20.9% in December 1920 and dipped to its lowest point, just above 2.3%, around the end of the equity market mania in April 2000. In those 100 years, the war premium is only barely visible.
The first Gulf War is instructive. During the bull market from 1983 through 2000, the market's earnings yield declined from 15% to 2%. This dramatic rise in prices relative to earnings occurred in the context of an exceptionally favorable macroeconomic environment for equities: trailing 10-year growth in real earnings advanced from a negative number to more than positive 6%, the inflation rate and its volatility declined by 70%, and the volatility of stock market prices declined by 30%. The 0.9% rise in the risk premium during the brief Gulf War is just a blip in this long bull market trend.
Since the peak of the stock market bubble in 2000, economic fundamentals have turned negative for stocks. Volatility of stock prices has risen by 25% and 10-year trailing earnings growth has fallen from 6% to 2%. Over this period, stock prices have plummeted and the market's earnings yield has doubled to 4.5%.
A war risk premium of 0.9% may be factored into today's earnings yield and may come back out with a successful conclusion to a war. And, this war premium may be significant to the short-term performance of the equity market. At an earnings yield of 4.5%, the 0.9% war premium translates to a potential price change of 20%. But the future path for earnings growth, inflation and volatility will be far more important in the long run than the consequences of war.
The war risk premium doesn't mean a lot in the long run. Investors should keep focused on economic fundamentals rather than become distracted by war.
Christopher J. Brightman is chief investment officer of Strategic Investment Group, Arlington, Va.