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Bulletproof Your Portfolio For A War In The Middle East Or Far East - The 5 Ws

This article is intended to provide the background information on a series that I am planning to author on how to invest so that your portfolio has some downside protection in the event of a war or major crisis.

Previous articles have explored how to manage certain investment risks while maintaining a high-yield portfolio. Inflation, deflation, credit risks, and various other economic factors can impact the value of your holdings. What should we be thinking about to protect our assets in the event of war or other major crises?

There are two geographies where there is a real risk of war, and the discussion and consequences are receiving political attention, but not as much from the investment community. The concern that I will address is how to prepare a portfolio for a possible war. This does not propose that you exchange your current portfolio management strategy for a new one; rather, that you consider holding certain securities as a form of portfolio insurance in the event of a war.

I have referenced and linked many other articles, so that the reader has supplemental information available. Please note that this article will not examine the ethics of profiting from a crisis or war - I will leave that to the more philosophical authors - and excludes the possibility and consequences of a global and/or nuclear war.

To start, let's examine the 5 Ws (who; what; where; when; why) of a war or major crisis, and the investment consequences. The subsequent articles will examine what sectors and securities fall into the "buy", "hold", and "sell" categories.

Conflict Candidates

First, let's identify the two current risks which would have global consequences:

Iran and Israel - Iran wants to build nuclear weapon capabilities, and as the likely target, the Israelis are unprepared to accept this risk. The current sanctions against Iran have had questionable consequences, and the Israelis have drawn their line in the sand (literally, a red line on a chart that expires in less than one year). The options at this point are: 1. Iran abandons this objective, or 2. Israel destroys the Iranian nuclear capability. Based upon years of headlines, and previous history (in 1981 and 2007, Israel destroyed the nuclear reactors of Iraq and Syria), I suggest that option 2 - the military choice - is most likely. It is a question of timing. The probable consequence of the attack is an immediate spike in the price of oil and gasoline, which would further exacerbate the European and Japanese recessions, impair already-tepid American and Chinese growth, and initiate a new flight to safety for capital (which has many business consequences). Simit Patel's Seeking Alpha Instablog, "What a War Involving US, Israel, and Iran Means for Oil" does a brilliant job explaining the potential impact of this war on oil prices. Similarly, "Pending Iran Military Action And The Historical Effect Of Wars On The U.S. Dollar", by another SA author, Ron Hera, looks at the impact of this potential conflict on the USD - which may not provide the currency safety that we would like.

China and Japan - Both countries are squabbling over the Senkaku (aka Diaoyu) Islands - about 6 square kilometers (under 4 square miles) in area (five uninhabited islets and three barren rocks) in the Pacific Ocean. Taiwan also claims sovereignty. This is by no means unique; Canada and the US have been parochially at loggerheads over certain rocks and ocean water on our mutual border for decades. Another example of long-time friendly countries disputing territorial ownership is Canada, Denmark, and others, have been quarrelling over who owns thousands of square miles of ice in the Arctic. Now that there may be oil and gas resources attached to these geographies, the respective governments are becoming more adamant in their sovereign claims; regardless, it is improbable that Canada and US or Denmark would do anything more adversarial than go to International Court over the conflicting claims. That said, this China-Japan dispute is different. They are historic enemies, and the popular opinions, press, and governments, are creating tensions on both sides. The consequences could be severe; both countries are major manufacturers, importers (e.g., resources from Australia, South America and oil from the Middle East) and exporters (in fact, China's 4th largest export market is Japan). Global supply chains depend upon both countries for manufacturing in other Far Eastern countries, North America, and Europe. The Wall Street Journal summarizes the impact on their respective GDPs in its article "China Row Hangs Over Japanese GDP":

A 30% drop in Japanese exports to China over the course of a one-year period could slice off 0.6% of Japan's nominal GDP, according to S&P estimates, which currently forecast growth of only 2.0% this year and 1.6% in 2013.

The immediate impact on China is more muted as only 8% of total Chinese exports go to Japan each year, driven by food and textiles-compared with the 20% of Japan's total exports bound for China, largely capital goods. But if ties continue to deteriorate, the Chinese economy wouldn't be immune and indeed Chinese partners of Japanese car makers have already felt some pain as sales have plunged.

Hopefully, negotiations will be successful - otherwise, the risk of a war may increase after the Chinese leadership change, and any subsequent negative economic forecast. A potential positive side-effect for the foundering Western economies is that in the event of a China-Japan war, the disruption could have the unintended consequences of repatriating manufacturing to North America and Europe, and localizing supply chains.

One can also identify in-progress revolutions in Syria and certain African countries, but none of these would likely have highly-disruptive global economic consequences, as they place at risk very small portions of the global economy.

Economic and Business Consequences

The potential participants in the wars may perceive economic and certain social benefits. For example, Japan may have a vehicle to exit their recession; China could address unemployment, declining GDP growth, and the male/female population imbalance; the countries would ramp-up military consumption and therefore, Gross Domestic Product (aka GDP), as part of mobilization. Generally wars provide a boost to domestic demand through higher military spending. War actually consumes and destroys resources on both sides - for example, Israel would build a $100M factory, assemble $1M missiles, and then use it to destroy a $1B Iranian nuclear reactor. Both the manufacture of the missile and the replacement of the reactor will add to the respective country's GDP. Infrastructure that is destroyed and/or refreshed would improve future productivity. Wars have historically accelerated research and development, deferred social issues, and have mobilized entire societies around certain goals. Although military historians seem to have concluded that there are greater economic costs than advantages, a great number of (small) wars are nonetheless underway.

Disadvantages - from the perspective of just-about every author - outweigh any possible benefits; wars kill and maim the young (who are the future of society), injure the innocent (often referred to as "collateral damage"), and create future burdens on society through caring for casualties, rebuilding housing and infrastructure, additional government borrowing, deficits, and national debt. The immediate negative economic impact of war is inflation and capital depletion. That said, the decision-makers have their own political and economic agendas, which may or may not be fully-endorsed by their populations. On the financial side, it may destroy economic assets (e.g., infrastructure, manufacturing), with the greatest potential social consequence being the destruction of food, water, shelter, hospitals and schools, and power, for the general populace. Environmental impacts - such as when the Kuwaiti oil fields burned for months during the Iraqi invasion - are rarely measured in consequential terms.

The conclusion is that the participants will incur certain costs and potentially obtain some benefits. Those not directly involved will gain from increased production of resources and military supplies, and lose from the increased oil and other costs.

War will introduce uncertainty and risk. The immediate financial impact of a war is that the stock market will drop. Domestic markets will plummet, and given the global economic linkages, all stock markets will adjust (downwards). Therefore, even a defensive portfolio may not protect you from an initial drop in value.

When it looks like shooting will begin momentarily the market takes a dump. What should you do with your stock, mutual funds or cash that is waiting to find a home? There is a saying "When in doubt get out". And that applies just as strongly today to everyone whether you are a professional trader or a retired person living off your equity income.

Funds and equities of the companies who have significant business in the revolutionary or war-zones will plummet. Let's look at what happened to the Egypt Index ETF Market Vectors (NYSEARCA:EGPT) as a result of the Arab Spring - the civil unrest started in January, 2011; although this is not a war, it is a similar crisis. Although I am by no means a technical analyst, the chart headed straight down for one year. For this ETF, the impact tracked to the Egyptian economy - one which would disrupt the oil supply, or involves a major economic power, would have a broader and global effect (chart courtesy of CIBC Investors Edge; arrow inserted by the author).

One day after the September 11 terrorist attack on the World Trade Centre, McClellan Financial Publications published "Wars, Disasters, and Their Impact on the Market" which suggests that the impact of a war or other major crisis is temporary:

Crises like the terrorist attacks this week against the United States are almost uniformly buying opportunities, eventually. What is important to understand is that the buying opportunity does not come the moment that trading reopens. The sellers have to exhaust their panic while the buyers have to build up enough courage to come back in. The turning point for the markets will come when the tide of the battle reverses, in whatever form that reversal is perceived by investors.

There are a number of supporting examples and graphs, in this article, which reinforce the immediate drop in the market, but eventual recovery.

It appears that the immediate-term action when hostilities commence is to sell equities which are non-strategic in your portfolio, and/or represent the greatest risk of devaluation. Historic stores of value, commodities, and necessities, such as food, may maintain their value, but based on previous history, the overall market should substantially drop. To quote "War and the Effect upon Stock Markets: It is a Global Phenomenon":

If history is anything to go by, one rule can be applied to the stock market at times of geopolitical unrest and war: conflict is good for equities, but only once investors become convinced that they are on the winning side. Early on it can be a volatile one-way ticket down.

Frankly, if one of these scenarios occur, I plan to continue holding my real estate, infrastructure, utilities, telecoms, and resources companies, which form the core of my equity portfolio, and ride-out the blip. I should add that none of my holdings are anywhere near a war zone - they are overwhelmingly in North America, and some in Australia. However, I do recognize that there will be a temporary downdraft, and feel that market timing is not for me - the dividend stream of my investments will compensate for the volatility until the market recovers. Perhaps this temporary slide will present a buying opportunity?

With this Instablog, I have attempted to build a foundation for a series of articles - this is the 5 Ws for a war in the Middle East or Far East, and the potential market response.

Now for the big question for investors. What securities should we buy, hold, and sell, to prepare for, or even in the event of a war?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.