Invest Wisdom

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Yesterday, the market dropped 1%. Most media outlets assigned the drop to fears that swine flu could cause a worldwide pandemic.

I’ll admit that I was first skeptical of the idea that investors would react that way to a disease that’s only infected 50 people and killed no one in the U.S. (as of last night). Tamiflu, which has been found to be an effective treatment, is already stockpiled. (And if it’s resistant to Tamiflu, stockpiles of other drugs are available.

Now don’t get me wrong. It sounds like this flu has the potential to be a big deal. I feel sorry for those who have suffered from it or died, and I know that I’m suffering from a bit of “boy who cried wolf” fatigue, after the bird flu and SARS false alarms. But swine flu causing the market to fall?

Well, before I went into a huff about how the markets and the media always blow a small problem out of proportion, I did a little research. Last year, the World Bank estimated that a massive pandemic, such as the Spanish flu in the early part of the 20th century would cause world GDP to drop by 4.8%. A “moderate” pandemic, such as the 1957 Asian flu which killed 14 million people, would hurt GDP by 2%. A mild flu pandemic, such as the one starting in Hong Kong in 1968, would hurt GDP by less than a percentage point.

The big question, of course, is how bad will this one be? And how much would the market suffer as a result of that?

A popular method of measuring world stock market values is to take a country’s total market capitalization (that is, the total value of all companies in the country) and divide it by the country’s gross domestic product.

Right now, the market cap of the S&P 500 is $7.5 trillion. The U.S.’s GDP in the fourth quarter of 2008 was $14.2 trillion. That gives us a ratio of about .53 .

The World Bank’s estimate was for world GDP, but let’s assume a potential pandemic affected the U.S. proportionally. The U.S.’s GDP is already expected to fall this year for other reasons, but let’s just measure what the swine flu’s impact alone would be.

In the event of a major pandemic, where U.S. GDP dropped by 4.8%, U.S. GDP would drop to $13.5 trillion. Keeping the .53 ratio, the S&P’s market cap would drop to about $7.2 trillion, which is a 4.5% 4.8% drop in the S&P 500’s value.

For a moderate pandemic, where GDP drops by 2%, you’d expect a 1.7% 2% market drop.

For a mild pandemic, where GDP drops 0.7%, you’d expect a 0.36% 0.7% drop.

The market’s drop of 1% yesterday (if it wasn’t paying attention to anything else, which is unlikely), factored in a pandemic somewhere between the mild 1968 Hong Kong flu and the moderate 1957 Asian flu, if you believe the World Bank’s numbers.

Now for my disclaimer: There are so many assumptions I just made that it’s difficult to list them all. The market cap to GDP ratio might not remain consistent in the event of a GDP drop, since investors tend to look past short-term setbacks. In other words, while GDP would drop 4.8% in the event of a major flu, would there also be a huge rebound once the flu passed? Does the current economy’s fragility make it more susceptible to a setback by the flu? And so on.

I do hope, however, that this helps put the crisis in perspective.

Come back later for my second post in my series on value investing.

Update: I now realize that I did a bunch of calculations that really just explained something very simple: the market cap should fall in proportion to the GDP’s fall. And a 1% drop in the market, would seem to project a 1% drop in GDP, which is somewhere between the mild and moderate flu pandemic scenarios. Not sure why actually sticking all those numbers in a calculator came up with slightly different numbers. It probably has something to do with rounding and dealing with trillions of dollars.

- Joe Light