Recent events unfolding in Syria are a good example of how quickly news can change and ripple through markets.
It appears that the Syrian leadership may have crossed a red line recently by using chemical weapons against their own people as part of an ongoing civil war. President Obama had previously warned that any use of such weapons would prompt a response by the U.S. While the U.S. has tried to avoid the trap of getting involved in a civil war, it is now boxed into a position where the president must act or lose credibility.
Reading the Tea Leaves
This situation is in flux and the facts may change wildly in coming days, but here is our best take on this unfolding geopolitical risk. First, while a strike has not been launched yet against Syria, it seems increasingly probable that there will be some sort of retaliation by the U.S., and possibly other allies, against the Syrian regime. If we are correct, that leaves questions regarding timing and what form the attack will take. Trying to guess the exact timing of the attack is folly, but the latest messages coming out of various politicians gives us a sense that it will likely occur sooner rather than later. The other interesting nugget running through the press is that the intent will not necessarily be to remove the current regime, but instead will be designed to send a message to the rest of the world that such acts will not be tolerated.
What Does Market History Say About Investing During a Crisis?
While situations like this are unnerving and create many unknowns, the historical playbook for events like the current conflict in Syria is that investors are typically not rewarded for dramatically reducing risk as the crisis is unfolding. In fact, for investors that have any time side on their side, it usually pays to use event-driven corrections as an opportunity to add risk to a portfolio. That may seem somewhat counterintuitive, but the data supporting the notion are compelling.
Ned Davis Research, an independent research provider, has an interesting study that looks back at 51 previous crises since 1907, and the associated equity market declines and subsequent recoveries coming out of those events. Some of the examples included in the study are the panic of 1907, the attack on Pearl Harbor, the U.S. intervention in Libya, the Gulf War, etc. While these events are scary in real time, the data show that the immediate reaction to a crisis often brings about very moderate declines in U.S. equities. The average loss was approximately 6.5% using the Dow Jones Industrial Average. The average duration of a crisis was 21 days, and the median duration was only 8 days, so these events don’t tend to last very long. The message is that while there is usually some short-term pain experienced in the heat of the moment, if one looks out over the next 6 to 12 months, any loss is usually followed by strong gains in equities. Returns in the six months following a crisis have been 9% higher, on average. One year later the average return jumps to about 14%. The median numbers are even stronger.
While no study can provide a concrete assurance that things will play out a certain way, this study is strong evidence that adding a little volatility during crisis episodes has typically paid off over a cyclical time frame.
Thoughts About Portfolio Allocation
Our current thinking is that as long as this crisis doesn’t spin out of control, then it may already be too late to reduce risk. Therefore, rather than preparing for defensive action, a wiser strategy is to keep portfolios positioned at neutral volatility, with the idea that we may add some risk and/or reduce some protection if the Syrian conflict escalates. We are planning some minor rotation trades into gold equities and gold, which could act as decent hedges if volatility intensifies. But our main strategy at this point will be to watch what unfolds, with an eye towards cutting some Treasury holdings if they rally, or adding some equity holdings if they fall and open up pockets of value as a result of this crisis.
Risks and Being Flexible
There are plenty of risks associated with the possibility of a U.S. strike on Syria. Will oil spike and take the wind out of the global economy? Will the war become a protracted affair? Will a U.S. strike create tensions between the U.S. and other parts of the world (namely Russia, Iran, and North Korea)? What if this sparks a wider conflict? These are just a few of the many potential unintended consequences, and I have intentionally skipped the real tragedy of war: the loss of innocent life. The bottom line here is that although we currently have an opinion on how to play this unfolding crisis in Syria from an investment perspective, we also have to be cognizant that this situation is fluid and can change quickly. If the facts do change and the crisis unfolds in a manner much worse than we currently expect, we are prepared to be flexible and change our focus back to risk management rather than the pursuit of additional returns.