Analysis / Q&A: Sharon and the Stock Market

Prime Minister Ariel Sharon's stroke caught the stock market at a unique point - an all-time high.

Prime Minister Ariel Sharon's stroke caught the stock market at a unique point - an all-time high. The TA-25 index closed at 850 points on Wednesday - up 187 percent from its nadir of 2003. It was only natural that as surgeons probed Sharon's brain to stop the bleeding, share prices would sink, bonds would reel and the shekel would plunge against the dollar.

Here are some of the questions being asked today, along with the answers.

How important is Sharon to the economy?

In large part, Sharon can claim credit for Israel's economic rally, for the end of the recession, and its extrication from the financial crisis of 2002. He can fairly claim credit for the sharp improvement in the country's fortunes during 2004 and 2005. Together with former finance minister Benjamin Netanyahu, Sharon instituted a courageous economic policy and, at the same time, managed to reduce terror, too. Then, the disengagement in the summer of 2005 created a positive diplomatic climate around Israel.

In general, 2005 was one of the best years Israel's economy has ever known. Robust economic growth, falling unemployment, the impressive rally of the tourism and real estate sectors, and the boom in trade and services, combined with foreign investment in emerging markets, brought billions in foreign investment to Israel, bolstering the already-positive direction and helping to lift the stock market to record heights.

Sharon's resignation from Likud and establishment of Kadima, and polls predicting he would win the elections, raised the threshold of optimism even higher.

Why is the stock market falling?

A healthy economic environment does not change in a day. But the high share prices did not only reflect the present economic situation, they also reflected fond expectations of significant advances on all fronts - diplomatic, political, economic, and even social. The market assumed Kadima would win the elections with no trouble and set up a stable coalition with Labor and a third party.

Some of the power centers that tarnished Israel's economic advance, such as the Likud Central Committee and the settlers, have been losing their clout. And Sharon led the far-reaching initiative of vacating the settlements and setting permanent borders.

Yesterday, all these happy predictions collapsed, or at least took a bad blow. The uncertainty is great and the economy needs stability.

What are the uncertainty factors?

Until now, the picture of what would happen here in the months to come had been a clear one, and there were some pretty good estimates of what would happen in the months to follow. All this has changed. It is not even clear who will be finance minister. The government is operating with no budget for 2006, and the situation of the coalition after the elections will probably not easily lend itself to running a clear-cut economic policy. Budget policy will be impaired if Kadima's power is reduced while Labor and Likud gain at its expense, creating a structure of three medium-sized parties.

Didn't investors realize this could happen?

Apparently not; too much was riding on Sharon. Without him, Kadima is a strange beast of a party; and without him, the chance of creating a leadership in the range of months and reaching an arrangement with the Palestinians is far lower. Even the mini-stroke Sharon suffered two weeks ago didn't send home the message to the market players, who continued to buy stocks and lift the market.

Why is the dollar surging? Why are bonds tanking?

It is not that the dollar is surging, it's the shekel that is weakening. On a day of economic shocks, a lot of players sell shekel-linked assets and shift the money to Forex-linked vehicles. This is why the dollar, the euro and other major currencies climb versus the shekel. The Forex market is the most advanced and liquid of the world markets, and it responds quickest to developments. Wednesday night trade on Forex Web sites was stormy, especially as local investors fear the increase in risk will induce foreign investors to reduce their holdings in Israeli shares and bonds.

Will the foreign investors flee?

For the time being, it seems unlikely, though they might scale back their exposure to the Israeli marketplace, and thus exacerbate the slump. Foreign investors came to Israel in part because of its unique characteristics and in part impelled by a global trend of investment in emerging markets. The graph describing our stock market is very much like the graphs of other stock markets. But foreign investors factor in the long-term trend of improvement in the Israeli economy and the diplomatic processes. From their perspective, Israel has a growing economy and is heading for an agreement that does not depend on Sharon alone.

How far will stocks fall?

That is anybody's guess; but in the short run, players expect volatility and sliding share prices. It will take time for the political picture to clear up, until which time the stock market will be on hold. Very much depends on next week's polls and how the powers consolidate around the three major parties.

Why didn't the stock exchange suspend trade and prevent the slide?

Ultimately, it would not have prevented shares and bonds from losing value. Also, trade gives investors a chance to respond to events, to try to earn from them or at least cut their losses. Suspending trade is done if the public lacks information, or has not had enough time to grasp the event or how to best respond to it, leading to a panic not driven by rational thought. The prime minister's condition had been known the night before and the public had enough time to grasp the event and consider how to react on the floor. Furthermore, every share sold means that somebody bought it; evidently many believe a 5-percent drop creates a buy opportunity.

What should we do now?

If we knew, we wouldn't be writing columns, we'd be living the life of Riley somewhere. But one can think of some immediate effects that would have economic ramifications.

1. The shares most vulnerable at the moment are companies that do business inside Israel, such as local real estate and tourism companies, hotels, aviation, and finances.

2. If the dollar continues to climb, the Bank of Israel may raise interest rates, which would hurt stocks and shekel bonds even more and, in the long run, also hamper economic activity. Export-oriented companies such as Teva, ICL and Makhteshim Agan need not be affected by the local political situation, but their share prices are affected by withdrawals from mutual funds, which have no choice but to sell assets in order to return the money.

3. This may induce investors to diversify beyond Israel - meaning, buy foreign bonds and stocks. It can be done through specialized Israeli mutual funds, some of which have done very well in the last year, or through ETFs that are traded on the Tel Aviv Stock Exchange and that track foreign indexes.

4. There is no reason to panic. A 5-percent slide in share prices is a normal thing in stock markets. After such steep gains throughout three years, and a boom year like 2005, a retreat had to be expected, even without Sharon's collapse. All the indexes have done is returned to their level of two weeks ago.

Spend the weekend digesting the developments and considering what to do. You have barely lost anything at this point.