Investing based on geopolitical events

By DAVID MOON, Moon Capital Management
January 6, 2008

When an assassin's attack killed Benazir Bhutto, leader of the Pakistan People's Party and candidate for prime minister, 10 days ago, financial markets around the world stopped and took notice. Pakistan has nuclear weapons. If terrorists can affect the outcome of its national elections, that's scary. And if political candidates are killing one another'

Either way, political unrest in a country that has weapons capable of destroying millions of people at once is not a good thing. The ensuing riots add to the concern about who is in control of the country and their weapons arsenal. That doesn't make investors feel warm and fuzzy either.

But should you be making investment decisions based on geopolitical events like that?

It is tempting, especially at a time when there's so much uncertainty in the U.S., albeit without the street rioting and assassinations.

That temptation, however, is the result of our all-too-human habit of focusing on the most recent events, not necessarily the most important or relevant events. In the short term, financial markets will react to all sorts of geopolitical, geological or even meteorological shocks, but those types of influences are fleeting and non-predictive of long-term price behavior.

In other words, don't bet your money based on wars.

Between September 1939 and August 1945, perhaps as many 70 million people died as a result of the Second World War. More than 400,000 of these were U.S. citizens. This period also included the eighth worst stock-market crash in U.S. history, when the Dow Jones Industrial Average declined more than 40 percent.

During the entire war period, however, U.S. stocks returned 98 percent, or more than 12 percent a year.

The Korean War, although gruesome on the battlefield, was even more generous to investors. Stocks advanced at an average annual rate of 18.85 percent from 1950 to 1953.

But don't think that military conflict guarantees excellent investment returns. During the 11 drawn-out years of the Vietnam War, stocks managed a mere 3.91 percent a year. It was among the worst 11-year periods for stocks during the 20th century.

Let's look at another series of events, this time a seemingly perfect storm of economic and political crises. Domestic and foreign confidence in the U.S. economy was faltering. A credit crunch, combined with increased worldwide demand for non-dollar-denominated investments, placed great pressure on the U.S. economy. The president's political capital had dwindled, even within his own party. He was accused of being little more than a front man for big business. New York banking giant J.P. Morgan was profiting nicely from a cozy relationship with the federal government.

Sound familiar? The year was 1896 and the president was Grover Cleveland. In one month that year, the Dow Jones Industrial Average dropped 17 percent.

But over the next 12 months, the Dow increased 72 percent. Over three years, the gain was 134 percent.

In each of these cases, the external events had little or no long-term impact on stock prices. The most influential factor on the subsequent multi-year move in stock prices was the level of stock prices relative to corporate earnings prior to the external event.

That is, future stock prices were a function of the attractiveness of then-current stock prices.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

Add me to your commentary distribution list.

MCM website