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7 war scenarios every investor must consider

By Michael Brush

War, at any time and place, makes the future harder to predict. But investors today shouldn't let the struggle against terrorism keep them from attempting to determine likely scenarios and how they might affect the markets.

To come up with a short list, a dozen or so experts in terrorism, international politics and the markets offered their ideas on the most likely outcomes. Naturally, no one really knows whether any of these scenarios will actually play out. But investors should keep one thing in mind: Bad things, unimaginable things, are likely to happen.

Given the way stocks have recovered recently, however, investors don't seem to be taking the new geopolitical risks into account as fully as they should, says Byron Wien, investment strategist at Morgan Stanley. Few advisers are helping investors draw the defensible conclusion that they should avoid stocks altogether because of the potential for sell-offs sparked by new terror assaults on U.S. or European soil.

Here's a list of some potential scenarios to consider.

Osama bin Laden is captured

This is not unthinkable, given the "Wanted: Dead or alive" mentality and a presidential order directing the CIA to undertake its broadest covert action ever. "The gloves are off," as one senior administration official put it. Unmanned, CIA-operated Predator aircraft with high-resolution cameras have been equipped with Hellfire antitank missiles for the job. What would happen if they succeed?

"You would get a heck of a rally," says Charles Gabriel, a political analyst with Prudential Securities. But it might be a good rally to sell into or short, say several market analysts, including Gabriel. The reason: Terrorist networks run deep throughout the Middle East and elsewhere. So capturing one leader won't finish the job. "The initial reaction would be a belief that we have solved the terrorism issue, even though we haven't," says Hugh Johnson, a market strategist with First Albany.

Finding bin Laden will be a difficult task, anyway. Human intelligence sources are scarce in the region. And the CIA has a history of bungling such operations. The most prominent example was an unsuccessful plot to assassinate Fidel Castro in the early 1960s. More recently, analysts point to failed the attempt to eliminate Sheik Fadlallah, the head of the Hezbollah, or the Party of God, suspected of masterminding terrorist attacks on U.S. Marines in the Middle East.

The war escalates

Short of a domestic nuclear strike by terrorists, the worst-case scenario is a full-scale jihad that draws in Muslim countries throughout the Middle East and Asia. "In other words, Osama bin Laden accomplishes what he wants to accomplish," says Johnson. Disruptions to oil supplies and the economy would hit the markets hard.

But Johnson and others see this as an unlikely outcome. The reasoning goes like this. Many governments throughout the world know they would risk getting thrown out of power if their economies turned down -- or if they lost access to capital -- because of a U.S. depression sparked by global conflict. "An extended American recession, leading to a global recession, will spawn widespread unrest and, perhaps, several regime changes," says Mark Melcher, a political analyst at Lehman Brothers. "Don't think for a second that the leaders of developing nations, who often hold a rather tenuous grip on power, aren't well aware of this relationship."

Afghanistan turns into a quagmire

During any military campaign, armchair generals come out in full force. This early on, it's probably best to ignore them. For one thing, there has been a lot of success. American warplanes command the skies, and much of the Taliban's infrastructure has been pulverized.

Besides, the armchair generals often get it wrong, anyway. Critics for example, claimed that NATO could not win its 1999 war with Yugoslavia, but after 78 days of bombing, it did. What's more, it is unlikely the U.S. will get bogged down in Afghanistan the way the Soviet Union did, since the plan so far is to avoid committing lots of ground troops. And views that the U.S. will have big trouble in the Afghan winter could prove wrong, as the cold weather may make it easier for Air Force heat-sensing equipment to find Taliban soldiers in their heated caves.

But you can expect things to take a long time. "The plan is to use special operations to capture al Qaeda personnel for interrogation to enable the capture of more of them and eventually roll up the organization," says John Pike, of GlobalSecurity.org, a Virginia-based think tank. "They are certainly not going to succeed quickly in the sense they are looking for a few thousand people in a country of 20 million."

For investors, this is not necessarily a bad thing. "Quagmire would be good for the market, as long as it is recognized as not being a defeat," says Melcher, the Lehman Brothers analyst. "The upside from quagmire will come if it ends up looking like a containable, festering boil," agrees Gabriel. "Even with the quagmire scenario, we will get something of a rally just because of all the stimulus, all this lighter fluid -- the fiscal stimulus and interest rate cuts, plus declining energy prices. At some point this is going to light on fire."

But will it be sustainable? Yes, barring other events that may play out during a quagmire in Afghanistan.

There are more terrorist strikes

For all the talk of "suitcase nukes" that supposedly shook loose from the Soviet Union while it was unraveling, terrorism experts don't put them high on their list of things to worry about.

"Terrorists work with governments, and those governments don't want to cross the nuclear threshold," says Angelo Codevilla, professor of international relations at Boston University. He says nuclear strikes don't really fit into their strategy, either. "The essence of the game is to cause the West enough harm, but not so much harm that the West will destroy them." There's also no credible evidence of "loose nukes," says Pike. "The U.S. government has never acted as if it believed it."

Most terrorism experts agree, however, that more attacks are coming. The way the market initially sold off with each fresh report of anthrax shows how it would react to another major terrorist attack. "If there is another major strike, we may have to retest the lows," says Gabriel. But the market is also in the process of learning how to adjust to more strikes and the new threat of terrorism. "We will absorb it," says Gabriel. "We will have to."

Likewise, most market analysts aren't concerned about the potential economic cost of a new "terrorism tax" -- the higher cost of insurance and security, for example. Sure, the mail and airport security will be slower. And more military spending may mean lower productivity growth. "But the terrorism tax is a just rearrangement of resources," says Johnson. "It is not necessarily a big positive or negative." It may be a plus, if it leads to more spending overall, which is likely. "Crisis leads to stronger economic activity and a stronger market because the way you deal with it is to spend money," says Johnson. Health-care stock analysts such as John Hancock's Linda Miller says the new focus on bioterrorism will speed up vaccine research, though it's not quite clear how to invest in it at the moment.

Dissent arises in the United States

"We have an election next year and the gloves could come off," says Melcher. "By next March, President Bush better have the public on his side and believing that he has done a good job. Because if he doesn't, it will become all right for the Democrats to complain." Divisions could arise inside the Republican Party, as well, over issues like government spending and the amount of aid handed out to private companies and others hurt by terrorism. There's also the potential for broader conflict over civil liberties. Deep, internal political divisions over these issues would bring uncertainty -- which investors hate -- leading to market weakness, says Melcher.

The war on terrorism destabilizes the Middle East

A lot of attention has focused on Pakistan. But a more likely candidate for unrest is Saudi Arabia because of internal pressure against the current rulers and their ties with the U.S., Codevilla says. He thinks there is a good chance Saudi Arabia could fall into the hands of anti-U.S. factions inside the country, who would turn oil into a political weapon. Embargoes could drive up the price of crude dramatically.

What will that do to the markets? "In this kind of scenario, it does not matter what energy stocks you own because they will all do well," says Jason Selch, an oil analyst with Liberty Wanger Asset Management. Cyclical stocks, meanwhile, would fare poorly as the higher oil prices cast doubts about an economic recovery. "I wouldn't put a high probability on it," says Selch. "But there is probably a greater than 10% chance that there is a major destabilization in the Middle East as a result of all this."

U.S. attacks spread to Iraq or elsewhere

"All the military action so far has been aimed at Afghanistan, the least significant spot on the face of the earth," says Codevilla. "If you had a magic wand and you could get rid of Afghanistan, our problems would not be appreciably ameliorated." Like other terrorism experts, he thinks terrorist networks run through many other countries, including Iraq, Syria, Sudan and Somalia. But the U.S. is putting off anti-terrorism efforts in places like these, in the hopes of not stirring up a bigger hornet's nest, he says.

Could that change? Perhaps, if there are further serious terrorist strikes in the United States, analysts say. Factions inside the administration already want to move things in that direction, once clear links between terrorists and countries beyond Afghanistan can be clearly demonstrated. Broadening out the war effort would bring a whole new set of uncertainties that would weigh on the market.

Given all the unknowns in this new kind of war on terrorism it will be hard to know when it's really over. The definition of victory is when you can go on to other things," says Codevilla, adding: "You and I are no longer worried about Hirohito attacking Pearl Harbor."

Fortunately, for investors, markets may learn how to live with these kinds of unknowns and move on, even before that.

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