Hedging terror

Last week’s events in London raise many questions, including this: ‘Can investors hedge against terror attacks?’ 13 months ago, I offered some thoughts on this topic in the wake of former attorney general John Ashcroft’s May 26, 2004 assessment that the US had a 90% chance of being “hit hard.” That day the following security industry stocks climbed an average of 23%:

• Digital Recorders (TBUS): +16%,
• Mace Security International (MACE): +31%,
• Magnetek (MAG): +23%,
• Ipix Corp. (IPIX): +12%, and
• American Science & Engineering (ASEI): + 33%.

Our research found that following 16 terror alerts between February 2002 and September 2004, these stocks rose an average of 9%, compared to no change in the S&P 500. Since the president’s reelection, terror alerts have evaporated but terror attacks have not. On July 7th, these security stocks rose an average of 26% after news of the London attacks:

• TBUS: +48%,
• MACE: +22%,
• MAG: +15%,
• IPIX: +37%, and
• ASEI: + 10%.

To be sure, all but one of these companies – ASEI, a maker of x-ray inspection devices -- loses money so holding them as long term investments would be risky. Furthermore, their stock prices tend to decay within weeks after terror fears subside.

But as a short-term hedge against terror attacks – and warnings thereof should they recur – the following strategy may prove effective:

1. Buy a basket of these stocks several weeks after a terror attack or warning;
2. Sell the basket of stocks a few days after an attack or warning; and
3. Repeat step 1

Given the poor financial condition of many of these companies, investors will need to alter the makeup of the terror stock basket as the weakest companies go out of business. But this should be a small price to pay for a financial hedge against a world of terror without end.