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Don&#39t panic

The prevailing mood of gloom caused by the Iraq crisis has meant that, despite the improved valuations on offer after three years of falling prices, few investors have been tempted back into equity markets. Many are adopting a wait-and-see strategy. Is this sensible?

Sentiment is a powerful mover of markets but fundamental factors such as valuation and growth always reassert themselves in the longer term following extreme surges in emotion.

The market correction following the tech boom of the late 1990s provides one of the most glaring examples of this. Despite the burden of excessively high valuations, prices moved higher, pushed up by real buying support. Eventually, of course, the bubble burst and prices fell back to discount a less rosy reality.

Markets are only fleetingly blind. Short-term fears do not change long-term goals and, when clarity returns, the path has to be regained and the lost ground made up.

What this means is that, while investors will occasionally stop putting money into equities because of short-term fears, most will eventually return to the asset class. When this happens, the market uplift can be increased dramatically by the wall of cash that has built up. Sellers become scarce, cash flows into the market are strong and speculators take profits or try to reverse positions. Even prolonged periods of weakness can be reversed in a short time under these conditions.

These circumstances can be illustrated by mapping market performance around the time of the Gulf War in 1991. As the crisis broke, markets fell sharply and remained weak as preparations for war were finalised. But, once the conflict had begun, the mood changed and investors suddenly found markets irresistible. The initial fall in prices saw the FTSE All Share index fall by some 16 per cent. In the rally, prices rose by 24 per cent.

As this type of bear phase develops, stocks generally become more volatile as investors with short-term horizons try to pull prices lower. The decline in prices can be gradual as the move towards conflict is punctuated by periods of hope. But recovery tends to be sudden. This is not an economic cycle where trends change gradually and where data is open to interpretation. A single stream of events is under close scrutiny and, once the worst has been discounted, there is a general attempt to move back to the neutral long-term position.

The effect is a rush into the markets as cash and bond holdings become asset mismatches when uncertainty fades. Generally, the end of the crisis results in an a more supportive background to investment to that which existed previously. As a result, prices do not simply retrace the ground lost, they go on to make new high ground.

But perhaps things are different this time. A number of commentators have suggested that the risks of the current crisis are greater because of the potential for further developments in the Middle East. As a result, the normal patterns will not apply. This can be used to justify the wait-and-see policy but, in reality, it is just another manifestation of the crisis mentality which we see from time to time. Each worry and each crisis is different in detail but similar in overall effect.

During World War Two, markets fell lower as the world moved towards crisis and the predicament of the isolated UK became extreme. However, the bear market did not endure for the entire conflict. In fact, prices reached their low point precisely when things looked most bleak – after the Dunkirk evacuation and before the Battle of Britain.

Over the previous three years, markets fell by some 52 per cent to a level which reflected the fears and concerns of investors but, arguably, not the long-term value of markets. Over the next seven years, as the threat diminished and better news came through, markets more than regained lost ground and rose by 165 per cent.

What we are looking at here is an example of an event-driven bear market, a market phase which is distinct and different from the cyclical bear phases with which we are more familiar. Event-driven bear markets tend to be shorter, more volatile and sharper-ending than cyclical bear markets. They occur when markets are threatened by factors which do not sit well in conventional valuation frameworks.

War is one example but eventdriven bear markets are not always related to conflict. The LTCM hedge fund crisis of 1998 also serves to illustrate the type. Investors need to maintain a balance. At times when investment markets are depressed, allocating money away from its natural long-term objective can appear in the short term to be an appealing and suitably cautious strategy. But, in the long term, the evidence is that it can prove to be damaging to performance.

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