The stock market tends to rally whenever the U.S. begins military operations overseas.
Does that mean that investors prefer war? Not exactly. But they positively abhor uncertainty, and that’s what typically characterizes the market environment in the weeks prior to the U.S. military becoming involved in a foreign military operation.
Much of that uncertainty gets resolved soon after U.S.-led hostilities begin, and that’s why the stock market typically soars in response.
This interaction between the stock market and uncertainty is key to understanding what’s going on now, with the markets struggling over the past couple of weeks in reaction to U.S. saber-rattling directed at North Korea and Syria. The Dow Industrials are 2.6% below where they stood on March 6, which is when North Korea launched four missiles into the Sea of Japan.
That uncertainty appeared to lessen this past weekend with the failed North Korean missile launch, though it quickly returned: Vice President Mike Pence said in a speech in South Korea that the era of “strategic patience” with North Korea was over, and a White House official was quoted to the effect that Trump was considering a “kinetic” action—including a sudden strike—against that country.
Meanwhile, in a development reminiscent of the dark days of the Cold War, U.S. fighter jets intercepted two Russian bombers off the Alaskan coast. That move comes after the U.S. bombed a military air facility in Syria, a close Russian ally.
This period of market weakness is likely to continue so long as uncertainty remains elevated. That could last for months. But a shrewd contrarian bet would be for a sharp rally if and when U.S.-led hostilities commence.
Consider how the Dow Jones Industrial Average has performed both before and after the U.S. military became engaged in past foreign hostilities. We focused on seven discrete events since the early 1980s:
• The U.S. invasion of Grenada (1983)
• The U.S. invasion of Panama (1989)
• The first Gulf War (1991)
• The U.S. bombing of Kosovo (1999)
• The U.S. war on Afghanistan (2001)
• The second Gulf War (2003)
• The U.S. bombing of Libya (2011)
This isn’t an exhaustive list of all of the U.S. military’s overseas activities of the past four decades. But each of these seven had a well-defined beginning date that allows us to measure how the stock market did in the weeks prior to those hostilities and thereafter. Other U.S.-led hostilities, such as the so-called war on the Islamic State, have had no such well-defined beginnings.
On average over the month prior to the beginning of these seven events, the Dow fell 0.6%, or 1.4 percentage points lower than the average of all months since 1983 (see chart). But this underperformance was quickly reversed: In the month after the U.S. military entered a conflict, the Dow soared an average 4.0%—3.2 percentage points greater than the average of all months since 1983.
Furthermore, the Dow’s strong performance continued for several more months. On average, over the three months after the start of these seven events, the Dow rose 6.7%, compared to an average gain of 2.4% across all three-month periods since 1983. And six months after those beginning dates, it was 7.2% higher, versus an average gain of 4.8%.
What accounts for this strong rally after hostilities began? A marked reduction in market volatility, which is one measure of risk. Not only does volatility tend to fall back to levels prevailing prior to when the threat of hostilities became real, it stays low for some time thereafter.
In a 2013 study, Mark Armbruster, president of Armbruster Capital Management in Rochester, N.Y., found that the stock market’s average volatility was significantly lower during four major wars of the last century: World War II, the Korean War, the Vietnam War, and the first Gulf War. And not by just a little bit: Large-cap stocks were 33% less volatile during these four wartime periods than across all periods since 1941, while small-cap stocks were 26% less volatile.
As we were taught in Finance 101, we should expect the stock market to trade at higher levels when volatility is lower. Sure enough, that’s what Armbruster found: Large-cap stocks gained 1.4 percentage points more per year during these four wartime periods than the rest of the time, while for small-caps, the margin was 2.2 percentage points.
It’s tempting to speculate about why volatility would be lower during wartime than the rest of the time. It perhaps traces to the tendency for our nation to become more cohesive during periods of hostility, focusing more on what brings us together rather than our differences.
This appears to have been a factor during the 2001 war in Afghanistan, which began less than a month after the Sept. 11 attacks. Even though the Dow had fallen more than 8% over the month before that war began, and even though that war took place during the 2000-2002 bear market and the associated deflation of the dot-com bubble, the Dow still gained 11.9% over the six months following the beginning of that war.
We aren’t aware of any particular sector bets that might make sense as a way of exploiting the market’s tendency to perform well when the U.S. military becomes engaged in foreign operations. Insofar as lower volatility is the underlying cause, then we should expect to see that improved performance throughout the market’s various sectors and investing styles. This would be why, for example, both large- and small-cap stocks experienced improved performance.
An important qualification is in order. Notice, for example, that each of the past military operations on which we base our analysis were discrete events with well-defined beginning dates. My findings would not apply to more diffuse military operations that are long, drawn-out, and often conducted in secret—such as the so-called War on Terror.
If the U.S. response to North Korea follows such a pattern, then investors shouldn’t bet on any particular stock market reaction one way or another.
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