The Greek debt crisis has been a factor in affecting the direction of world stock markets, at least for the time being.
While no one can predict what the true long-term consequences will be, there have been similar fallouts in history that might give a clue.
Mark Hulbert had some thoughts on this topic in “Tragedy or Comedy?”
The difference between a tragedy and a comedy, I was taught in Classics 101, is that, in the latter, the hero wakes up in time.
I take this to mean that it’s premature to label the current fiscal crisis in Greece as a tragedy, as many commentators nevertheless are already doing. It might in the end turn out to be a tragedy, but it doesn’t have to.
This is especially worth remembering after a day in which the stock market plunged as Greece’s debt was freshly downgraded (this time to “junk” status). The Dow Jones Industrial Average fell by more than 200 points, or 1.9%. The S&P; 500 had an even worse day in percentage terms, shedding 2.3%.
But investors can’t really have been all that surprised by the downgrade of Greek debt — or at least shouldn’t have been. John Dessauer, editor of an investment advisory service called John Dessauer’s Outlook, argued in an interview last week that it was almost certain that Greece would end up defaulting on its sovereign debt, either outright or de facto.
In any case, Dessauer furthermore argued, the impact on the world economy of an outright Greek default would be fairly modest. That’s because the damage to world trade inflicted by the Greek crisis has already happened — and for the most part has been already priced into the level of the stock market.
Dessauer’s point is confirmed by a recent analysis I conducted of the stock market’s reaction to past sovereign debt crises. Interestingly, Greece’s sovereign debt crisis is hardly unique. And the stock market on average has performed quite well in the wake of past such crises.
Over the last two decades, I counted at least four major sovereign debt crises:
* The Mexican peso devaluation and associated crisis, which began in December 1994.
* The so-called “Asian Contagion” that began in July 1997, when a government debt crisis in Thailand led to a run on its currency. That in turn precipitated similar crises throughout the region, leading many to fear that the crisis might eventually spread around the world.
* The Russian ruble devaluation in August 1998, which led to (among other things) the bankruptcy of Long-Term Capital Management
* The Argentine government debt/currency crisis that began in November/December 2001
The accompanying chart is based on a composite of how the stock market reacted following all four cases, with 100 representing the stock market’s level when those crises first broke onto the world financial scene. On average the stock market was 17% higher in one year’s time (as measured by the Wilshire 5000 Total Market Index).
The chart also shows how, on the same scale, the stock market has reacted so far to the Greek crisis. Notice that, more or less, the stock market is following a similar script. In fact, even with Tuesday’s big drop in the stock market, it nevertheless remains ahead of the average experience in the wake of the four prior debt crises.
This analysis doesn’t amount to a guarantee that the stock market will perform as well this time around, needless to say. There is a big leap of faith involved in extrapolating from this — or any — historical analysis, especially one based on a sample containing just four examples.
Still, this analysis does serve to remind us that the negative impact of a sovereign debt crisis, scary as it otherwise may be, can also be exaggerated.
At the same time, you are well advised not to make hasty investment decisions just because a crisis has affected markets temporarily. The next one will be lurking on the horizon for sure, so it pays to stay with your strategy, as long as the major trends remain up and your sell stop points have not been violated.
It’s important to remember that once a negative event becomes known, any further consequences are likely priced in the markets already and will have less of an effect than initially. It’s the unexpected that can wreak havoc on Wall Street, at least temporarily.
That’s why it’s most beneficial for you as an investor to keep your emotions in check, let the markets do what they do, but have a plan in place to deal with a change in trend direction by using your sell stops to get your portfolio out of harm’s way.
