"The Korean Peninsula, War and the DJIA - Does History Provide a Clue?"

Sydney M. Williams

Thought of the Day

“The Korean Peninsula, War and the DJIA – Does History Provide a Clue?”

November 30, 2010

There are growing concerns that rising tensions in the Korean Peninsula may be felt in equity markets. A week ago, North Korea began shelling the island of Yeonpyeongdo, which lies in disputed waters south of the Northern Limit Line, but north of the Military Demarcation. Unlike the torpedoing of the Cheonan last March, this was an overt action. The North Koreans did not deny their responsibility for the deaths of two soldiers and two civilians and the homes they destroyed on the island. They were emboldened by the lack of response to the attack earlier in the spring. Whether retaliation (other than joint military exercises in the Yellow Sea with the U.S., but without live ammo and a refusal to attend the six-party talks) from the South will be forthcoming remains in doubt. Nevertheless, Zbigniew Brzezinski (President Carter’s national Security Advisor), in last Tuesday’s Financial Times, wrote: “It is an outrageous action that could qualify even as an act of war.”

In the fifty-seven years since the armistice was signed on July 27, 1953, there have been numerous skirmishes, but the recent escalation is worrying. North Korea is a nuclear power. Not unnaturally, China has been flexing its muscles in the region. The United States is occupied in the Middle East and Afghanistan; Iran remains a problem. A leadership transition is underway in the North. Kim Jong-iI recently promoted his young son, Kim Jong-un, to Four Star General, an indication that he is being groomed to become the next “Supreme Leader”, though any actual change may be years away. And there must be grizzled, senior army officers who are a little miffed to have to report to this 27 year-old. While North Korea appears politically erratic, Stratfor, in a note out last Thursday, stated: “North Korea’s notoriously irrational behavior is actually deliberate, carefully cultivated and purposeful.” Stratfor, in the same piece, points out that the North has struck recently with impunity, which may have given them increased confidence. They also raise the question, “… is this ability to calculate weakening as a result of the internal strains of the power transition, or other unseen factors?”

Seoul lies in the northwest of South Korea, about fifty kilometers from the Demarcation Line, in easy target distance for conventional artillery fire. Moreover, the immediate environs of Seoul comprise, according to Stratfor, about 46% of the population and 24% of their annual GDP, making the country vulnerable should Pyongyang decide to get more aggressive. On the other hand, despite China’s refusal to condemn North Korea’s actions, she can have no interest in seeing this incident ballooning into a full-fledged conflagration. But China is interested in increasing her military strength and presence in East Asia. Among her interests, not surprisingly, must lie in supplanting the United States as the dominant naval force in her part of the world.

The situation on the Korean peninsula highlights the problem of rogue nations – those with little or no skin in the international geo-political game of diplomacy – gaining nuclear weapons. It also underlines that far more important than the START Treaty is the imperative need to build missile defense systems. The Wall Street Journal’s front page article this morning on Russia’s moving short-range tactical nuclear warheads to facilities close by our NATO allies serves to emphasize the need for missile defense. Regardless, one nuclear weapon, in the hands of North Korea or Iran, is more dangerous than six hundred or a thousand such weapons in Russia.

But to return to the title of this piece, there is little in the history of the last hundred years that provides a pattern for the future, should hostilities in the Korean peninsula become war. The market generally sells off in the initial months (or first couple of weeks, in the case of the First Gulf War), and generally rallies through the end of the war. In World War I, the NYSE shut down for the first four and a half months – with the DJIA opening about 30% lower when it finally opened in December 1914. However, by the Armistice the Averages were up 21.2% at 88.06, providing a compounded return of 4.5%.

On Saturday, December 6, 1941 the DJIA closed at 116.60. After Pearl Harbor the Averages declined, bottoming on April 28, 1942 at 92.92 six weeks before the Battle of Midway on June 4. As one of the most decisive battles during World War II, investors came to believe that the Allies would ultimately prevail. By VJ Day (August 14, 1945) the market was 41.3% higher than it had been on December 7, 1941 .

.When the war (police action) in Korea began on June 25, 1950, the DJIA were at 224.35. Three weeks later, on July 13, the Index was at 197.46, down 12%. However, three years later when the Armistice was signed on July 27, 1953, the Averages were 19.7% higher than they had been when the war began, providing a compounded return of 6.2%.

During the eleven and a half years of Vietnam stocks gained 9.6% - from November 2, 1963 when South Vietnamese President Ngo Dinh Diem was assassinated, with at least tacit approval of the Americans, until April 30, 1975 when South Vietnam President surrendered unconditionally to North Vietnamese Colonel Bui Tin and helicopters lifted the few remaining Americans from the roof of the embassy, compounding at a dismal 0.8%. On the other hand, using the Gulf of Tonkin Resolution passed by the Congress on August 7, 1964 as the starting point for the Vietnam War, the DJIA flat-lined for ten years, nine months – 829.15 to 821.34.

The First Gulf War began on August 2, 1990 with the DJIA at 2864.60 and ended February 28, 1991 with the DJIA 2882.18. The current Iraq/Afghanistan Wars stem from 9/11. On Monday, September 10, 2001 the Averages closed at 9605.51. They reopened a week later and closed that day, September 17, at 8920.70, down 7.13%. They closed the year at 10,021.50, but we were in the middle of a bear market that had nothing to do with the Islamic terrorist attack, so the market continued to sell off until making its low in October 2002.

Economic conditions, along with the secular/cyclical waxing and waning of investor enthusiasm, appear to play more important roles in the stock market, at least over time, than do military conflagrations. One might conclude that war helped bring us out of the Depression during World War II and that war aggravated the economy during Vietnam, as President Johnson pursued a policy of “guns and butter”. But, as is normal in our business, there are no easy answers.