The outcome of these historical events is a pattern of investor behaviour that can help us understand how investors and markets are reacting to the current crisis.

The first phase is one of shock and a collapse in share prices. It is followed by recovery as investors seek to build a perception of fair value. The next phase is a second take on fundamental value, factoring the effects of the shock event into economic and corporate forecasts. During this period of uncertainty, earnings are revised downwards and share prices tend to go lower. However, analysts are working with incomplete information so forecasts are often unreliable.

The third and final phase is triggered by the release of information aimed at addressing the cause of the initial shock. Observations of recent shock scenarios have shown that a high in equity markets was reached as soon as a perceived solution to the problem was reached. For example, stocks recovered sharply from the moment that bombing of Iraq started in January 1991. What is bad news becomes good news for market sentiment.

ADVICE FOR INVESTORS
The three-phase theory is a useful way to look at stock market behaviour under the current circumstances. Overall, it helps us to better understand the mechanics of share price movements in times of crises. It is now clear that 2001 will register a second consecutive year of falling stock markets throughout the world--the first time in almost 30 years.

Regardless of the recent uptick in global markets, we are clearly in the midst of a crisis of economic, financial and political proportions. Such a scenario was last encountered in the 1973 and 1974 bear market when the Middle East oil producing countries were again at the fore.

What can institutional and individual investors do? The simple answer is more of the same: intensify fundamental research and try to look beyond the short-term confusion. Sound balance sheets and strong cash flow generation are, once again, sought after corporate attributes.

FOCUS ON FUNDAMENTALS
In such irrational markets, short-term considerations dominate and sentiment begins to overshadow fundamentals. In a corporate context, the magnitude of the fall in prices implies, in many cases, that a once robust business model is flawed and doomed to failure. This exaggeration, coupled with political uncertainty, is affecting the confidence of many corporations. As a result, management is reluctant to offer any glimmer of optimism in their short- to medium-term predictions.

Corporate statements are adding to the uncertainty in investors' minds. Perhaps we are entering a phase (towards the end of phase two outlined above) of overkill, as investors become too pessimistic. Such pessimism will inevitably present attractive investment opportunities.

Fundamental research is once again an extremely important source of adding value. Rather than trying to find the solution to the current crisis, it may be more rewarding to ignore the current and short-term emotional noise generated by the media and concentrate on long-term corporate fundamentals. Despite the economic and corporate trends, these fundamentals are beginning to look a lot more appealing. BC

Peter Hadden is the director, institutional clients department with Baillie Gifford Overseas Ltd. in Scotland. peter.hadden@bailliegifford.com.