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Why stocks are 'underreacting' to the destabilization of Iraq

Philip Pearlman
Breakout

Last week, it started becoming clear that the situation in Iraq was quickly taking a turn for the worse.

Things have unraveled further this week as the Sunni militant group, the Islamic State in Iraq and Syria (ISIS), continues to attack more cities throughout the region. This is a fluid and quickly shifting situation; earlier today, CNN reported that ISIS has advanced to Baquba, only 37 miles north of Baghdad.
 
To date, equity markets have not really responded negatively to the destabilization of Iraq, a nation with the fifth-largest oil reserves in the world. The S&P 500 (^GSPC) lost 0.7% last week, but that's a very minor giveback after a three-week long rally which added 3.8% to the index.
 
Crude oil futures have rallied about 5% over the last 10 days. But even there, the argument can be made that price is not fully discounting risks that are suddenly becoming apparent. Crude futures have not yet challenged 2013’s highs just above $110 per barrel and were recently trading at $106.64.
 
Perhaps the ungluing of Iraq is no big deal and financial markets are responding rationally to what appears to be an accelerating risk, but really is not a threat to the continuing, albeit subdued, economic recovery.
 
On the other hand, perhaps the market is behaving in a way that is familiar to behavioral economists - by underreacting to new and surprising information while market participants only gradually process the new information.

Markets tend to oscillate between overreaction and underreaction. This has been supported by a variety of behavioral economic research.

MIT professor Andrew Lo summarizes over and underreaction phenomena succinctly: “A common explanation for departures from the efficient markets hypothesis is that investors do not always react in proper proportion to new information,” he writes.

Put another way, people are not perfect information processors and it takes us time to fully wrap our heads around the implications of new and surprising information. If the human brain is like a computer, it's more like a Commodore 64 than IBM’s (IBM) Watson.

Overreaction is the term used to describe situations in which a broad market or a specific asset continues to move in a direction significantly past what given measures deem fair value. It is a byproduct of momentum, where new money continues pouring into an asset over time, in part, because the asset has already risen.
 
Underreaction tends to occur when surprising and fundamentally relevant information becomes public. It occurs, in part, because humans do not perfectly and fully process this new information instantaneously, but, instead, only integrate it gradually over time.

The most common form of underreaction occurs when a company reports a large earnings surprise. Often, the stock will move in the direction of the surprise, as some participants process the new information quickly, and then drifts in the same direction of the surprise over a period of one or a few months.
 
More Questions Than Answers

As the U.S. Government, the media and the markets were all caught offguard by ISIS’s sudden and aggressive moves in Iraq and Syria, perhaps, the muted reaction in equities is a case of underreaction and we are setting up for a further drift lower in stocks as investors further process the new dynamic.

The tendency with underreaction patterns is that magnitude of the initial move on the surprise, to some degree, anticipates the magnitude of the continued drift in the same direction. If that is the case, then markets might experience only a very modest amount of downward pressure given the shallowness of the last week’s sell off.
 
Perhaps the market is almost fully processing the Iraqi situation but does not view it as bearish at all, and instead interprets recent events as another opportunity for the U.S. Government to spur industrial growth via increased defense spending - in other words, an economic tailwind.

Notably, the invasion of Iraq in March 2003 occurred at the beginning of an incredibly bullish period for stocks; the S&P 500 rose 36% in the ensuing 12-months and 50% over a three-year period. However, the beginning of the Iraq War coincided with the end of a huge bear market spurred by the bursting of the Internet bubble. This is a very different situation than we have today, but it does warrant some consideration.

Perhaps we are in such a bullish phase for stocks, the market has been negatively affected by Iraq and is simply going up less than it otherwise would be.

My own guess is that the muted equity price response and even the less-than-expected rally in crude oil is more a reflection of the continuing uncertainty of the situation. In sum, markets have no idea whether this is the beginning of a much larger and entrenched situation, or if it will be contained and will wait for clarity before making the next move.

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