Why does the stock market index get affected when a terrorist attack takes place?

Question

The way I see it, the stock exchange is a market where shares of a company are traded. These trades are triggered by individual valuations by participants of what an investment in a company would be worth. I mean, the participants think like this, don't they?:

I expect the company to distribute 'X' as dividends for the next few years. So if I invest 'A' amount now, the dividends could help me recover my 'A' over a period of time. Hopefully, there would be other people around after a few years who'd think that the company would start distributing 'X + Y' amount as dividends. So they'd then make their valuations and be willing to pay a nice price to buy a share which I'd then gladly accept and pocket a handsome profit.

How exactly would a terrorist attack make people value the returns from a company less and less (if that's what a drop in the stock price implies)? And that too the shares of almost all companies by majority of the investors/traders? I just don't get the intuition.

Answer 1

There are more than a few different ways to consider why someone may have a transaction in the stock market:

1. Employee stock options - If part of my compensation comes from having options that vest over time, I may well sell shares at various points because I don't want so much of my new worth tied up in one company stock. Thus, some transactions may happen from people cashing out stock options.

2. Shorting stocks - This is where one would sell borrowed stock that then gets replaced later. Thus, one could reverse the traditional buy and sell order in which case the buy is done to close the position rather than open one.

3. Convertible debt - Some companies may have debt that come with warrants or options that allow the holder to acquire shares at a specific price. This would be similar to 1 in some ways though the holder may be a mutual fund or company in some cases.

There is also some people that may seek high-yield stocks and want an income stream from the stock while others may just want capital appreciation and like stocks that may not pay dividends(Berkshire Hathaway being the classic example here). Others may be traders believing the stock will move one way or another in the short-term and want to profit from that. So, thus the stock market isn't necessarily as simple as you state initially.

A terrorist attack may impact stocks in a couple ways to consider:

1. Liquidity - In the case of the attacks of 9/11, the stock market was closed for a number of days which meant people couldn't trade to convert shares to cash or cash to shares. Thus, some people may pull out of the market out of fear of their money being "locked up" when they need to access it. If someone is retired and expects to get $x/quarter from their stocks and it appears that that may be in jeopardy, it could cause one to shift their asset allocation.

2. Future profits - Some companies may have costs to rebuild offices and other losses that could put a temporary dent in profits. If there is a company that makes widgets and the factory is attacked, the company may have to stop making widgets for a while which would impact earnings, no? There can also be the perception that an attack is "just the beginning" and one could extrapolate out more attacks that may affect broader areas. Sometimes what recently happens with the stock market is expected to continue that can be dangerous as some people may believe the market has to continue like the recent past as that is how they think the future will be.

Answer 2

While JB King says some useful things, I think there is another fundamental reason why stock markets go down after disasters, either natural or man-made.

There is a real impact on the markets - in the case of something like 9/11 due to closed airport, higher security costs, closer inspections on trade goods, tighter restrictions on visas, real payments for the rebuilding of destroyed buildings and insurance payouts for killed people, and eventually the cost of a war. But almost as important is the uncertainty and risk. Nobody knew what was going to happen in the days and weeks after an attack like that. Is there going to be another one a week later, or every week for the next year? Will air travel become essentially impractical? Will international trade be severely restricted? All those would have a huge, massive effect on the economy. You may argue that those things are very unlikely, even after something like 9/11. But even a small increase in the likelihood of a catastrophic economic crash is enough to start people selling.

There is another thing that drives the market down. Even if most people are sure that there won't be a catastrophic economic crash, they know that other people think there might be and so will sell. That will drive the market down. If they know the market is going down, then sensible traders will start to sell, even if they think there is zero risk of a crash. This makes the effect worse. Eventually prices will drop so far that the people who don't think there is a crash will start to buy, so they can make a profit on the recovery. But that usually doesn't happen until there has been a substantial drop.