Godspeed to all of those souls who’ve been injured, killed or have lost loved ones this week – by my count the number is over 700 casualties and counting, between the two affected regions. Tonight we’re going to talk about how geopolitical threats affect the stock market.
It’s a big topic, but there have not been many profound writings on the subject of late, so here’s my take:
Suffice it to say that there is never any more or any less risk of geopolitical threat in the world – there are only changes in perception and the attention paid to the various threats, new and old, that have been with us since the dawn of time.
The notion that there is more uncertainty now than there was last month because of a plane being shot down in the Ukraine or an Israeli incursion into Gaza is both childish and ahistorical. Just because we choose not to be concerned with uncertainty at a given moment – like on September 10th, 2001 for example – that doesn’t mean an outbreak of violence or hostility is any less likely to occur.
So what we’re discussing here now is not a rise in uncertainty itself – but a rise in the awareness of that uncertainty and its subsequent effect on stock prices.
And there is a notable rise in the awareness of uncertainty as I type. Events around the world are now in motion that, while not economically significant, could have a large impact on the investment markets – whether they should or should not is a question we won’t bother with at present.
When geopolitical tensions flare and the investor class sits up at attention, the character of the stock market tends to change almost immediately.
The first change we notice is that momentum-oriented trades and stories are quickly abandoned. This is because these stocks are typically held by Greater Fool-playing investors who are not fundamentally bullish on them in the first place but are merely betting on future buyers to continue to prop up their prices. The non-committal nature of these types of players leads to cascading sell-offs in the stocks they’ve been riding. Prices do not matter, nor do any of the attributes of the underlying companies. Bulls will cry outrage at the “oversold” conditions in their favorite companies while upbeat analysts and other believers will use terms like “it’s overdone” and “the baby’s being thrown out with the bathwater.”
It won’t matter, so long as risk is being shed in a hurry by the momentum pros – who’ve learned one lesson the hard way, many times: Live to ride another day.
All stocks can get hit, of course, but the ones that deserve it get it the worst. Geopolitical events have a bizarrely just and equitable way of meting out punishment precisely where it’s most deserved in the stock market. No one knows why this is.
We saw this behavior during the opening salvo of the Russian-Crimean-Ukrainian fight this February and March. None of the technology stocks or biotech stocks that saw declines of between 20 and 40 percent had any involvement with the conflict or the effected region whatsoever. But they were sell-able so they were sold, largely by fast-money funds who’d never even bothered to learn their names or their businesses. They just put the money on the dresser and snuck out the side door.
The other effect that the awareness of geopolitical uncertainty has on the stock market is the onset of multiple compression. When the world wakes up to a threat it hadn’t considered or that did not originally seem terribly worrisome, it begins to reprice risk. This procedure occurs in commodity markets, currency markets and bond markets, often in a synchronized manner around the globe. And it happens in the stock market as well – just not necessarily in its most obvious form, which is selling. No, sometimes risk is repriced more subtly across the stock market, especially when a threat seems potent enough to make us nervous but remote enough to keep us from panicking. The Russia vs Ukraine or Israel vs Palestinian conflicts both offer great examples of this.
In a repricing of risk scenario, we start to see good news ignored and people less willing to pay a higher multiple for stocks – even when they’ve announced results or initiatives that would clearly deserve it. Our inability to become excited by great news or fresh developments becomes evident in this way only over time. The inner monologue goes something like this: “Wow, I’m really impressed that Chipotle just shocked The Street with double-digit same store comps this month…but, my god, 300 passengers on a civilian airline were just shot out of the sky over Eastern Europe!” That extra lot of shares simply doesn’t get bought. People become resigned to hold what exposure they already have until “all that uncertainty dies down.” Obviously, the media plays a major role in this phenomenon, feeding it around the clock on screens everywhere. Don’t be mad, it’s kind of their job.
This repricing exercise, writ large and unfolding in the shares of every publicly traded company in every sector of the market means multiple compression. It means an underwhelming response to even the best possible news as investors read the morning headlines and decide, “I’m good for now” when it comes to adding to their positions. This is, of course, only exacerbated by the diminution of inflows from unsophisticated investors, who read geopolitical flare-ups as stop signs. The longer an event remains in the news, the greater the chance of their allocations to the market slowing or shutting down entirely. “I’ll start adding to my 401(k) once things cool down a bit.”
Now it’s worth remembering that the human animal is endlessly prone to distractions and is always looking for something new to focus on. What this means is that most bouts of geopolitical fear quickly subside or are grown accustomed to. There’s no formula for calculating the speed and depth of how this sequence needs to play out. Sometimes the War Pigs give us a steady stream of uncertainty to fret over for an extended period of time and sometimes things ratchet down quickly and quietly without so much as a peep in the aftermath. Eventually, the same old headlines will be treated with derision or meet complete and total apathy as the system decides subconsciously that the event has already been fully assessed and appropriately “priced in.”
Each time is different, by definition every one of these episodes brings with it a set of variables and unique dynamics that no investor has a readymade answer for in advance. Models, frameworks, heuristics and rules of thumb will be totally useless here. Awareness of this digestive process, on the other hand, will be priceless.
The Moving Finger writes; and, having writ,
Moves on: nor all your Piety nor Wit
Shall lure it back to cancel half a Line,
Nor all your Tears wash out a Word of it
– The Rubaiyat of Omar Khayyam