Credit: Shutterstock photoSAN DIEGO (ETFguide.com) Do disasters , natural or otherwise, send stock prices spiraling? According to the media, they do (just think of the headlines right after the earthquake). But what do the facts say. Here are the five most devastating disasters and how they affected the stock market.
Please note that the intent of this article is not to minimize or over emphasize the extent of one event over another. The events below are sorted based on perceived effect on the U.S. economy.
1) Indian Ocean Earthquake - December 26, 2004
This undersea earthquake had its epicenter off the west coast of Sumatra. The earthquake and the resulting tsunamis killed over 230,000 people in 14 countries. There was no immediate effect on stocks. A low came 20 trading days later when the S&P had corrected 3.8%. It went on to rally as much as 35% thereafter.
2) Haiti Earthquake - January 12, 2010
The 7.0 earthquake and some 52 aftershocks killed an estimated 316,000 people. There was no immediate effect on stocks. The S&P closed as much as 6.6% lower 18 trading days later, but continued to rally thereafter.
3) Hurricane Katrina - August 29, 2005
Hurricane Katrina is said to have been the costliest natural disaster in the history of the United States. Property damage caused by the hurricane is estimated to exceed $80 billion.
Surprisingly the S&P greeted the hurricane with an eight-day, 3% rally. 38 trading days the S&P was 2.4% lower. In terms of stock market performance, the most costly natural U.S. disaster was no more than a footnote; it couldn't even be picked out on a chart.
4) September 11 Attacks - September 11, 2001
9-11 is probably one of the most defining moments in United States history. Following the attack, U.S. stock markets closed and remained that way for the rest of the week. Once the market re-opened, the S&P lost 11.6% in four trading days.
The panic selling, however, was short-lived and the Dow Jones (DJI: ^DJI), S&P (SNP: ^GSPC), Nasdaq (Nasdaq: ^IXIC), and Russell 2000 (Chicago Options: ^RUT) recovered to pre-9-11 levels within a month. It is often omitted that the S&P had already lost 16% before the planes hit the World Trade Center.
5) Japan Earthquake - March 10, 2011
Even though the scope of the Japan earthquake has yet to be fully comprehended, there is no doubt that the combination of earthquake, tsunami, and nuclear meltdown will have a long lasting effect on Japan and that ripple effects could be felt the world over.
Two other events of interest are the Northridge earthquake, which hit Los Angeles on January 17, 1994. The stock market had no discernable reaction to this event and doubled over the next two years. The nuclear accident in Chernobyl on April 26, 1986 also had no noteworthy effect on stocks.
Purely based on a historic correlation analysis between (natural) disasters and the stock market, it appears that even catastrophic events do not alter the market's performance.
If that is the case, what is the reason behind the 23% drop in Japan's Nikkei (NYSEArca: EWJ)? How much will Japan's devastation affect the U.S. stock market?
Assessing the Ripple Effects of the 'Tsunami'
One reason that may help explain the steep decline in Japanese equities is sentiment. Extreme optimism is one of the most bearish forces known to the markets.
According to TradeFutures.com, 93% of Nikkei 225 Futures traders were bullish just days before the earthquake hit. This was not just a one-day spike of bullishness, it had been accumulating for weeks and reached the highest reading since the Nikkei's 2007 highs.
Extreme bullishness over prolonged periods of time is troublesome because it turns potential buyers into owners. The only thing a stocks owner can do is sell.
Following the 2007 highs - both in terms of price and sentiment reading - the Nikkei declined more than 50% without the 'help' of an earthquake. Sentiment extremes are not unique to Japan's market.
The ETF Profit Strategy Newsletter warned of this condition in the U.S. markets several times over the past few years. In January 2009, right before a 30% drop, the Newsletter recommended to exit all long positions.
The same warning occurred in January 2010 before the markets corrected 10%. In April 2010 the Newsletter's warning of excessive optimism protected investors from the 'Flash Crash' and a near 20% slide. Even though the April 2010 sentiment was off the charts, the market managed to exceed it just recently (thanks to QE2).
On February 18, 2011 the ETF Profit Strategy Newsletter noted another spout of unbridled investor enthusiasm and cautioned that: 'Historic extremes tend to lead to reactions of historic proportions. A fast and steep sell off from current prices is possible.'
As it turned out, stocks topped that very day. The S&P lost as much as 7%. The financial sector (NYSEArca: XLF) was down as much as 8.2%, the technology sector (NYSEArca: XLK) 9.4%, small caps (NYSEArca: IWM) 7.3%, and mid caps (NYSEArca: MDY) 6.4%.
Bad News Everywhere
In addition to bad news from Japan, there's been a steady flow of troubling developments in the Middle East and a still brewing banking crisis in Europe. This has led to an 11.2% haircut for the international iShares MSCI EAFE ETF (NYSEArca: EFA).
But - and that's a big but - the major indexes did not break below important structural support levels. The February 18 ETF Profit Strategy Newsletter mentioned that only a break below 1,255 would unleash more bearish potential. The S&P poked a few points below 1,255 on Wednesday March 16 before recovering in a big way.
The media has quickly abandoned its panic mode, headlines about Japan have become scarce and the focus has shifted back to positive earnings. Rather than following emotional reasoning, it makes sense to rely on technical analysis to assess the market's prospects.
The ETF Profit Strategy Newsletter provides long, mid and short-term technical forecasts, along with the one immediate support level that needs to hold for the bullish potential to remain alive.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
