Israeli Investors Skeptical of War?

I've long been a supporter of using specialized stock markets as a tool for predicting events. Which is why I was disappointed when the Pentagon prematurely aborted its market in terrorism futures, and why I'm excited about on-line betting on whether hurricanes will strike certain areas or not (serious look at this issue here and here, totally non-serious look from the Daily Show here) and the growth of hedge funds that use catastrophe bonds to profit from forecasts of violent storms.

Now, I'm intrigued with the work of two economists who claim that the Israeli stock market can be used as an indicator of whether or not Israel's counterterrorism strategies will work or not. The conclusions of the report, "Assassinations: evaluating the effectiveness of a counterterrorism policy using stockmarket data" (PDF), are simple to understand:

Our approach relies on the assumption that the market should react positively to news of effective counterterrorism measures but negatively to news of counterproductive ones. The main result of the analysis is that the market reacts strongly to assassinations of senior members in Palestinian terrorist organizations: it declines following attempts to assassinate political leaders but rises following attempts to assassinate military ones.

To make a long story short, terrorism so affects the Israeli economy that investors are bullish when the country takes effective anti-terrorism steps and bearish when it takes ineffective steps. Effective steps include assassinating high-ranking leaders of the military wing of a terrorist organization, because it reduces the ability of the organization to recruit and train terrorists and plan attacks. Ineffective steps include killing leaders of the political wing of a terrorist organization, because it does nothing to reduce the ability of the organization to attack militarily and probably helps them recruit new suicide bombers, etc.

The economists analyzed more than 100 Israeli assassination attempts between 2000 and 2004. They found that the Tel Aviv 25 index dropped by an average of 1.1% whenever the Israeli government attempted to assassinate a Palestinian political leader. It climbed by an average of 0.6% whenever the government attempted to assassinate a Palestinian military leader. Interestingly, large terrorists attacks against Israel resulted in an average drop of 1.2% - a response only slightly greater than if Israel killed a Palestinian political leader.

The July 22-28 issue of The Economist applies this economic analysis to Israel's current conflict.

The decline in the Israeli stockmarket as Israel's conflicts with Hizbullah and Hama have intensified - 9.4% between July 10th and July 13th, though it has revived since - may reflect more than the expected financial response to unrest and uncertainty. If a recent study of the Tel Aviv Stock Exchange is any guide, Israel's targeting of Palestinian political leaders in response to the capture of its soldiers has been counterproductive.

Of course, Israeli investors could just be fearful of what the future holds - WWIII, more attacks on Israeli cities, increased taxes to pay for a protracted occupation of parts of Lebanon, etc - even if they think the underlying counterterrorism measures are correct.

Economist article here. (Subscription required).