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Investing During International Crisis

Last week’s market action showed how volatile markets can be in the wake of geopolitical turmoil. Is there a way to profit?

 

Last Friday, we learned that airstrikes hit Iranian-backed militias in eastern Syria, killing at least eight.

As I write Monday morning, the group responsible for the attack is still unclear.

Meanwhile, on Friday, we also learned that the Trump administration is expanding sanctions against Iran — a move that is certain to add to the tension in the region.

And did the markets sell-off on this news?

No — they set a new all-time high before pulling back based on mildly disappointing numbers in the jobs report.

On Friday, the Dow topped 29,000 for the first time in history before giving back gains because payrolls increased by 145,000 instead of the predicted 160,000. Of course, unemployment is still holding near a 50-year low.

As I write Monday morning, markets continue to shrug off the potential for more unrest in the Mideast, as the major indices are all pushing higher.

But Friday’s attack and the fresh sanctions reveal that perhaps we’re not out of the woods yet when it comes to tension in the Mideast — even though the markets are acting as though we’ve gotten an “all clear” sign.

Unfortunately, as we’ve seen many times, all it takes is one unexpected geopolitical event to send stocks spiraling.

So, if another attack happens and the markets drop, how should we respond?

Might a severe attack be the straw that finally breaks the camel’s back — or in this case, the bull’s back? Or is the U.S. stock market so strong that any upcoming market pullbacks stemming from geopolitical conflicts should be viewed as buying opportunities?

Last week, John Jagerson and Wade Hansen of Strategic Trader delved into this topic of “external” risk, and how we should view it as investors. So, in today’s Digest, let’s turn to our resident quants to get their thoughts on how to play external events that roil markets.

We’ll then take it a step further by identifying the one question you’ll want to ask yourself before taking any investment action during times of conflict.

Let’s jump in.


***The “externalities” that can send markets reeling

 

John and Wade began their update by establishing some context for their study:

… there is a subset of market events that exist in their own category. We usually refer to these issues as “externalities” because they do not arise from the normal ebb and flow of the business cycle. They are imposed on the market from outside.

Classic examples of externalities are hurricanes, earthquakes or blizzards, which can have a temporary impact on the market …

“Geopolitical risks” are another category of externality, and while a geopolitical risk isn’t a natural phenomenon, it is outside of the business cycle.

Given that this latest geopolitical event involved Iran, John and Wade noted the impact on the most commodity to be affected — oil.

They referenced how during the first few months of the 2010 “Arab Spring” uprisings, oil jumped 40% — but those gains were short-lived.

Interestingly, we’ve already seen this same “rise-and-fall” dynamic play out on a much smaller scale in the last few days. Oil’s price action last week illustrates how drastically emotions play into market pricing.

To illustrate, last Wednesday, U.S. crude rose nearly $3 in the wake of the Iranian missile attack. However, after Trump calmed markets, U.S. West Texas Intermediate (WTI) crude fell $3.09, or 4.9%, to settle at $59.61 per barrel, and then continued to sell off.

Below, you can see the sharp spike in prices, followed by the sudden reversal.

 

This volatility begs a question — when these external events shake markets, can we brush them off as temporary abnormalities, or might they truly change pricing on a sustained basis?

From John and Wade:

… the magnitude of the effect a geopolitical risk has on the market is nearly impossible to predict because we do not have a long-term track record of similar enough events to draw conclusions.

Although our data are limited, we think it’s still productive to look for some similar patterns that emerge during events like this to at least give us some perspective. Perhaps we can even create some benchmarks to monitor for a warning that things may be getting worse from a market perspective.


***Looking at past geopolitical events to help predict the future

 

At this point in their update, John and Wade noted how, traditionally, the U.S. dollar, gold, the Swiss franc and the Japanese yen act as safe-haven “stores of value” when traders are stressed. Watching their price-action reveals the stress in the markets.

From John and Wade:

As you can see in the following chart, the rally in gold and the Swiss franc preceded the assassination of Soleimani and Iran’s retaliatory attacks, but the trend has accelerated since that time.

 


Source:TradingView

The last time safe havens moved in a coordinated way like this after a “geopolitical risk event” was the bombing of a Saudi Arabian Aramco pipeline in Abqaiq on Sept. 14, 2019.

The risk of an escalation at the time boosted safe havens and oil, but the effect was short lived as you can see in the chart above.

Given how the duration and magnitude of these external events can vary so much, John and Wade suggest that it’s more useful to consider the reaction the market has when the risk starts to fade — and here, they highlight a key takeaway:

Unless the underlying economic fundamentals are affected, rebounds following crises like this tend to be robust.

As one example, John and Wade point toward the Russian invasion of Crimea in February and March of 2014. They note that investors had trouble pricing in the risk that NATO, and therefore the U.S., would become involved in an armed conflict with Russia.

And though the issue never fully resolved, the market settled over the summer of 2014, then rallied 9% as you can see below.


Source:TradingView

 

From John and Wade:

It may sound odd to compare the escalation of conflict in Crimea with the current issues between the U.S. and Iran, but it is the nature of risks in this category to be unique.

What wouldn’t be unusual is a rally in the aftermath of the conflict with Iran. Assuming further problems can be averted, there could be great opportunities to profit in the short term.

A similar post-crisis pattern emerged after the North Korean tensions of August 2017 when the market gained 18%. After the Eurozone debt crisis in October 2011, the market gained 27%.

Given these historical case studies, it suggests that investors who step in when fear is elevated are often rewarded when geopolitical tensions ease and markets snap back. A good thing to keep in mind if we see further attacks in the Mideast.


***But as John and Wade note, there’s one key question to ask …

 

Have fundamentals changed?

So, asking that question in the context of our current situation, if we see another Iranian attack, will it have a profound impact on actual oil production? Or, perhaps, might a prolonged escalation impact the actual financials of U.S. defense companies? Could it limit the profits of U.S. multinationals operating in the Mideast? These are the questions to ask.

The knee-jerk reaction to an external event will be fear and selling, but if you can’t make a case for a true change in fundamentals, history suggests it’s time to buy.

Have a good evening,

Jeff Remsburg


Article printed from InvestorPlace Media, https://investorplace.com/2020/01/investing-during-international-crisis/.

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