In Crisis, Opportunity

Luskin Report ^ | September 12, 2001 | Donald Luskin

[Wyatt's Torch]

THE LUSKIN REPORT In Crisis, Opportunity Donald L. Luskin Wednesday, September 12, 2001

The destruction of life and property in yesterday's terrorist attack on New York and Washington was horrendous, and we will pay its emotional and financial costs for years to come.

But if America's leadership and the American people respond constructively -- as they always have in the past -- then from this crisis could emerge significant opportunities that could propel the economy and the markets into an important new growth phase. In the past, terrifying crises like this have ended up bringing out the best in America -- and that has always been reflected in powerful stock market moves.

As I write these words on Tuesday night, I don't know yet when the US stock markets will open for trading. When they do, there is a chance that they will open significantly lower as a natural knee-jerk reaction of fear and uncertainty. But if history repeats itself, Tuesday's horrors could be the catalyst the economy and the markets have been looking for. Forgive me if this seems mercenary in light of Tuesday's loss of lives -- but this could be a major buying opportunity.

In a moment, I'll examine several great crises over the last forty years-- and we'll see that in each case, crisis presented opportunity.

Why? Because crisis mobilizes the commitment of human energy -- from what economist John Maynard Keynes called our "animal spirits." In the 1930s he recognized that the world's great depression was, as much as anything else, a collapse of animal spirits, the failure of a discouraged people to take risks and commit their energies. Today in our post-boom recession we find ourselves in much the same psychological state of hopelessness and fear.

The terrible damage done to the physical capital of New York and Washington can be seen -- perhaps heartlessly, you will say -- as a liquidity event. It is commonplace lingo of the insurance industry to refer to such tragedies as "the involuntary conversion of assets into cash." Involuntary indeed, and surely the product of great evil. But liquidity nonetheless: the fact is that all this infrastructure will be rebuilt in different forms, and the skilled and hard-working people who do the rebuilding will deservedly make a lot of money in the process.

There were terrible losses of human capital, as well. But that, too, will be rebuilt in different forms. And the new people who have to rise to the occasion to learn new skills and seize new opportunities in order to realize those different forms will deservedly make a lot of money in the process.

And while this rebuilding goes on, an entire economy's animal spirits can be rekindled. In his statement from the White House Tuesday night President Bush focused on mourning and on retribution. I hope that in future statements he focuses on the spirit of recovery. If I were writing his script, I'd advise him to say this:

"This has been an unprecedented tragedy, and we will catch and punish the people responsible for it. But life goes on. So I hereby commit the entire resources of the federal government to rebuilding the World Trade Center within a single year -- replacing the destroyed twin towers with two new ones that will be the tallest buildings in the world."

I would advise the New York Stock Exchange and the NASDAQ to resume trading as soon as humanly possible, provided they can be confident that trades will settle accurately. And I would advise the Federal Reserve should slash interest rates immediately by at least 50 basis points to facilitate the liquidity necessary to absorb Tuesday's losses and begin to rebuild.

If these steps are taken, then crisis will become opportunity. Here's how similar dynamics have played out in the past, as America's resilience has snatched victory from the jaws of defeat.

The Cuban Missile Crisis

The Cuban Missile Crisis of 1962 has many of the same dynamics as the current crisis, in that saw the sudden emergence of a potentially devastating military threat against which it was not at all clear how to defend or retaliate.

On Monday, October 22, President John F. Kennedy publicly announced the discovery of Russian nuclear missile installations in Cuba, his decision to quarantine the island, and his demand that the missiles be removed. The markets gapped lower that day, and traded all week in a volatile range while the drama played out. I was only a child at the time, but I clearly recall the palpable terror of that week. Those "13 days in October" were surely the closest the world ever came to global nuclear war -- and people knew it.

But the stock market never closed during the crisis. It was useful that the worst of it occurred on a weekend when the markets were closed anyway -- on Saturday, October 27, a US U-2 spy plane was shot down over Cuba, and Kennedy and Soviet Premier Nikita Kruschev went "eyeball to eyeball," as the saying was back then. On Sunday, Kruschev blinked -- he promised to remove the missiles, and the crisis was over.

On Monday, October 28, the markets opened with a gap -- higher than they were before the crisis was even announced in the first place, and then just kept on surging toward new all-time highs.

S&P 500 during the Cuban Missile Crisis Daily from July 1 1962 to January 31 1963

Just over one year later, the market would go through another crisis -- and the result would be the same.

The Kennedy Assassination

At 1:40 pm on Friday, November 22, 1963 reports of the assassination of President Kennedy in Dallas began to filter into the markets. Within minutes stocks began to plummet, with the S&P 500 losing about 3% in a little over 20 minutes. The New York Stock Exchange halted trading. It was the first time in the history of the Exchange that trading had been suspended in the middle of a session.

Over the weekend both the tragedy and the strangeness of the assassination sunk in, made all the worse by the killing of accused assassin Lee Harvey Oswald by Jack Ruby. Monday was a day of mourning, and the New York Stock Exchange did not open for trading.

Respect for the slain President and investor protection were not the Exchange's only motives in closing on Monday. The previous Wednesday the brokerage firm of Ira Haupt & Company had become the first major firm since the great depression to declare insolvency. The potential for cascading defaults made the Exchange eager to shut down while it arranged bail-out funds.

By the end of the day on Monday, the nation was confident that Presidential power had transferred smoothly to Lyndon Johnson, and that the assassination had been an isolated incident. That threat was over -- and so was the threat from Haupt. $12 million was committed to shield the public from losses -- and that was big money back then. When the market opened on Tuesday morning, it gapped higher than it had been before the assassination -- and just as it had a year earlier, it surged to new highs.

S&P 500 during the Kennedy assassination Daily from July 1 1963 to January 31 1964

36 years later another crisis would play out its own version of the same pattern -- combining solutions to simultaneous political and financial catastrophes. The results were the same: new highs for the market.

The Gulf War

On Thursday, August 2, 1990, Saddam Hussein's Iraqi army invaded neighboring Kuwait. The market tumbled violently from all-time highs, and kept falling through the rest of autumn while tens of thousands of allied troops amassed in Operation Desert Shield.

When Desert Shield went live as Desert Storm on Thursday, January 17, 1991, the markets gapped up and -- once again -- surged to new highs.

The risks of disrupted oil supplies and the fear of terrorist action engendered by the Gulf War were only part of the problem in late 1990 -- and the allied victory of Saddam Hussein was only part of the solution. While the Gulf war was unfolding, America was slipping into a stiff recession and there was a looming banking crisis.

Ground zero for the banking crisis was colossal Citibank, which faced insolvency thanks to a moldering portfolio of bad third world and real estate debt. Ironically, while the Gulf was playing itself out, New York Fed President Gerald Corrigan was busy brokering a bail-out of Citibank by Saudi prince Alwaleed bin Talal. And in the background, Fed Chairman Alan Greenspan was steadily lowering interest rates.

S&P 500 and Fed Funds Target during the Gulf War Daily from July 1 1990 to February 28 1991

But don't get to optimistic about Greenspan's role as savior here. According to the account of this period in Maestro, Bob Woodward's biography of Alan Greenspan, the rate cuts had nothing to do with the crises being faced then. Greenspan's reaction to the impending Gulf war was for the Fed "...not to be acting but to be perceived as providing a degree of stability." According to Woodward, the sequence of cuts during this period was intended more as a reward to President George Bush and the congress for working to reduce the federal deficit with that year's budget.

But that's not the way the markets saw it on Tuesday. The fed funds futures on the Chicago Board of Trade stopped trading at 10:15 EDT, but while they were open they registered the strongest possible optimism that Greenspan would act, and that he'd do the right thing.

Based on the pricing of the futures at Tuesday's early close, the markets now expect a 25 basis points rate cut within the next ten days as a virtual certainty. There's even a 45% chance that there will be a 50 bps cut in the next ten days. A 25 bps cut by the October 2 FOMC meeting is absolutely beyond doubt now. And a 50 bps cut by the meeting is now an 80% probability.

Looking out to next year, the futures now see it as a certainty that cumulative rate cuts will be even greater than 50 bps.

CBOT 1-month Fed Funds Futures As of Tuesday September 11 2001; Early close

This market hasn't been for the faint of heart for quite a while. And nothing in Tuesday's news made the world a less risky place for investors -- or anyone else. But that said, I've been saying for weeks that we've needed a catalyst to pull the markets out of their tailspin. I never could have guessed that a coordinated terrorist attack on the United States would be that catalyst. But it just might. Watch carefully -- look for the animal spirits rising from the ashes.

[Wyatt's Torch]

Aside from the seemingly crass focus on profiting from disaster, I think he is right on as to what Bush should say.