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Al-Qaeda just gave us something new to worry about. Liquid bombs, 20+ UK nationals involved, a dozen or more aircraft targeted. It was going to be bad and the question for everyone is: “What if we don’t stop them the next time?” Not only is the potential loss of life immense and tragic but investors – from the smallest retail trader to the biggest hedge funds – have to ask: “What does this mean for the markets?”

There is some history to guide us. Although every situation is different, when disaster strikes, it always appears as if the world is ending. The day Germany invaded Poland on September 1 1939, the S&P was at 11.19. The market took a dip but then became resilient and closed a week later at 12.69.

When North Korea invaded South Korea, the S&P 500 fell from 19.14 to 18.11 the day after the invasion and reached a low point of 17.27 a month later. Six months after that the S&P 500 was 21.03. On October 22 1962, when John Kennedy announced there were nukes in Cuba the S&P fell from 55.59 to 53.49 by the day’s end. A week later, the market was at 55.72 and six months later it was at 70.14, beginning a bull market that would last seven years.

Worse situations for the market were the bombing of Pearl Harbor and the Arab Oil embargo in 1973. Pearl Harbor took us down 4 per cent the day it happened and it was several years before the market recovered fully. On October 19 1973, the oil embargo was announced. The market was 3 per cent lower the next day and 17 per cent lower six months later. However, the oil embargo wasn’t enough to take the markets down. The week after the embargo was announced, the market was 2 per cent higher from the close the day before the embargo had been announced.

Shocks to the geopolitical situation, by themselves, throw off the market temporarily but are not enough to clog the wheels of industry. Time and again the markets have rebounded from horrible and tragic situations.

After the attacks on September 11, the S&P 500 fell from 1092 the day before to a panic low of 944 the week after. But six months on, in spite of the Enron bankruptcy, war in Afghanistan and the stirrings of trouble at Tyco and WorldCom, the market closed at 1165. I could even sell my apartment at a historic bottom for real estate prices in Tribeca, right next to the World Trade Center.

I think at this point, with interest rates pausing and the market trading at its lowest ratio of market cap value over earnings in more than 15 years, it’s time to look at some of the biggest value plays for safe bets. As I have said before, I think two of the best are Wal-Mart and Microsoft. Both have disappointed investors but that’s about to change. Everyone is afraid these mega-large caps cannot grow at all and, with Microsoft, people are worried about the temporary Vista delay.

Wal-Mart has increased book value per share every year for 10 years, including the recession year of 2001. At the end of 2000, Wal-Mart’s book value was $5.80, with the share price hovering in the $50 range. Now, with book value at a much higher $11.67, the stock price is lower, at $45. Wal-Mart’s average price-to-earnings ratio in the past 10 years was in the 30s. Now, shares are at their lowest multiple-to-cash flows since the 1970s, at 17.

For Microsoft the story is even better. It is still a growth stock. It is true that they’ve messed up on almost every level. Vista couldn’t be released for Christmas.
And, with the internet finally hitting critical mass, its MSN product just cannot catch fire. MSN lost out in the battle for AOL’s search services, and last week in the battle for MySpace.com’s search services.

Vista and Microsoft Office will be coming out early next year and the revenue and income boost will be significant. The market has so much discounted the possibility that Microsoft might delay again or, never release them, that the stock is trading at its lowest multiple over cash flows yet, according to ValueLine. The company is buying back another $20bn worth of stock. In addition, it is starting to establish a record of regular dividend increases. I think a cushion on this stock is about $21.50 with potential for $30-35 by the end of next year.

Every hedge fund is sweating now. For the third year in a row, hedge fund indices are in low single digits at the mid-year point. No strategy is working well enough for anyone to say they’ve found Nirvana. But keeping a cool head during trouble and looking for the pockets of value will work in the long term.

james@formulacapital.com

Copyright The Financial Times Limited 2017. All rights reserved.
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