Mar 2, 2022 12:55:03 PM
In recent posts, we’ve looked at both the fundamentals underlying market response to the Ukraine invasion, as well as the historical data around similar events. The conclusions were generally reassuring to us as investors. Today, though, I want to do something a bit different. Rather than consider the specifics and what they might mean, I want to ask more general questions. How should we be thinking about this? And can we use that to draw any conclusions around the likely next developments?
Evaluating a Novel Situation
What I mean by this is that when we evaluate a novel situation, we have different mental models we use, often without thinking about it. As I was working through the implications of the invasion, for instance, I found myself switching between two very different modes of thought. The first said this will soon pass, and we should be thinking about what comes after the invasion. The second, though, said we don’t know where this is going or how bad it will get—and we can’t look past it until we do.
For simplicity’s sake, let’s call these two models the natural disaster model (what comes after the hurricane?) and the pandemic model (which tries to figure out when, or if, this will end). Both are useful, but they give very different thought processes and conclusions, and it was not clear to me which was the better model.
The natural disaster model treats the invasion like a hurricane, which comes in, does a lot of damage, and then has an extended cleanup. The pandemic model treats the invasion as the first wave of trouble, to be followed by an indeterminate number of waves of subsequent problems. Of the two, for me at least, the pandemic model is the more intuitively appealing. It captures the inevitable second-order problems and effects that will be caused by the invasion. The natural disaster model simply looks too simple.
Natural Disaster Model
Yet when you review the market data from yesterday, the natural disaster model is a much better fit with how markets treat such events. The initial event hits markets, which then assess and respond to the damage and start recovering. This model also seems to be a better match for lived experience. When Russia invaded and annexed Crimea, for example, the world went back to normal quite quickly, to the extent that most of us did not remember that Russian invasion of only eight years ago. In this sense, yesterday’s invasion is likely to pass quickly both from the markets and from memory. If that is the case, then the natural disaster model will hold, and the effects should be short-lived. We won’t be talking about this in a couple of months.
That may be. But I still find the pandemic model compelling, and we need to think that through further. In the pandemic model, Ukraine would be the first wave: shocking and damaging, but ultimately not the worst of it. In this case, subsequent waves could well be Russian takeovers of other countries. Looking at the geopolitical map, that could be countries that, like Ukraine, were historical buffers between Russia and the West (e.g., the Baltics or Poland) or countries that historically were part of the central Russian core (e.g., Belorussia or Kazakhstan).
A one-off event could easily become a pattern if Putin is able and willing to make it so. If it happened once, it could happen again. That is what we need to watch for—the shift from a natural disaster to a pandemic.
Time Will Tell
Right now, the outcome is likely undetermined and the next several weeks will be critical. If Ukraine fights back effectively, and if the West stands together, we maximize the chance this invasion will “only” be a natural disaster. If not, and Putin sees this as a valid and successful strategy, then the likelihood of an extended pandemic-style series of wars becomes much more likely.
And this is why we need to consider both models in our analysis. Both are useful, but they give very different thought processes and conclusions, and it is not yet clear which is the better model. Right now, the natural disaster model seems like the best fit for the data, which is good news for us as investors. But I will be watching future events to see if the pandemic model starts to become more relevant.
Feb 24, 2022 1:24:29 PM EST
The next phase in the Ukraine crisis has begun, as Russia has launched attacks on Ukraine. With a war underway, it’s unsurprising that the markets are reacting. Before the market opened, U.S. stock futures were down between 2 1/2 percent and 3 1/2 percent, while gold was up by roughly the same amount. The yield on 10-Year U.S. Treasury securities has dropped sharply. International markets were down even more than the U.S. markets, as investors fled to the more comfortable haven of U.S. securities.
Markets Hit Hard
News of the invasion is hitting the markets hard right now, but the real question is whether that hit will last. It probably will not. History shows the effects are likely to be limited over time. Looking back, this event is not the only time we have seen military action in recent years. And it’s not the only time we’ve seen aggression from Russia. In none of these cases were the effects long-lasting.
Context for Today’s Events
Let’s look back at the Russian invasion of Georgia, and the Russian takeover of Crimea, which is part of Ukraine. In August 2008, Russia invaded the republic of Georgia. The U.S. markets dropped by about 5 percent, then rebounded to end the month even. In February and March 2014, Russia invaded and annexed Crimea. The U.S. markets dropped about 6 percent on the invasion, but then rallied to end March higher. In both cases, an initial drop was erased quickly.
When we look at a wider range of events, we largely see the same pattern. The chart below shows market reactions to other acts of war, both with and without U.S. involvement. Historically, the data shows a short-term pullback—as we will likely see today—followed by a bottom within the next couple of weeks. Exceptions include the 9/11 terrorist attacks, the Iraqi invasion of Kuwait, and, looking further back, the Korean War and Pearl Harbor attack.
Still, even with these exceptions, the market reaction was limited both on the day of the event and during the overall time to recovery. In fact, comparing the data provides useful context for today’s events. As tragic as the invasion of Ukraine is, its overall effect will likely be much closer to that of the Russian invasion of Ukraine in 2014, when Russia annexed Crimea, than it will be to the aftermath of 9/11.
Capital Market Returns During Wartime
But even with the short-term effects discounted, should we fear that somehow the war or its effects will derail the economy and markets? Here, too, the historical evidence is encouraging, as demonstrated by the chart below. Returns during wartime have historically been better than all returns, not worse. Note that the war in Afghanistan is not included in the chart, but it too matches the pattern. During the first six months of that war, the Dow gained 13 percent and the S&P 500 gained 5.6 percent.
Headwind Going Forward
This data is not presented to say that today’s attack won’t bring real effects and hardship. Oil prices are up to levels not seen since 2014, which was the last time Russia invaded Ukraine. Higher oil and energy prices will hurt economic growth and drive inflation around the world and especially in Europe, as well as here in the U.S. This environment will be a headwind going forward.
To consider additional context, during the recent waves of Covid-19, the U.S. economy demonstrated substantial momentum. Looking ahead, this momentum should be enough to move us through the current headwind until the markets normalize once more. In the case of the energy markets, we are already seeing U.S. production increase, which should help bring prices back down—as has happened before. Will we see effects from the headwind caused by the Ukraine invasion? Very likely. Will they derail the economy? Not likely at all.
Historically, the U.S. has survived and even thrived during wars, continuing to grow despite the challenges and problems. That is what will happen in the aftermath of today’s attack by Russia. Despite the very real concerns and risks the Ukraine invasion has created and the current market turbulence, we should look to what history tells us. Past conflicts have not derailed either the economy or the markets over time—and this one will not either.
Consider Your Comfort Level
So, should we do anything with our portfolios? Personally, I am not taking action. I am comfortable with the risks I am taking, and I believe that my portfolio will be fine in the longer term. I will not be making any changes—except perhaps to start looking for some stock bargains. If I were worried, though, I would take time to consider whether my portfolio allocations were at a comfortable risk level for me. If they were not, I would talk to my advisor about how to better align my portfolio’s risks with my comfort level.
Ultimately, although the current events have unique elements, they are really more of what we have seen in the past. Events like today’s invasion do come along regularly. Part of successful investing—sometimes the most difficult part—is not overreacting.
What Does the Russia-Ukraine Crisis Mean for Investors?
Feb 23, 2022 2:03:13 PM EST
I have been holding off on commenting on the Russia-Ukraine conflict until some sort of resolution occurred. Lots of things could have happened, and we could drive ourselves crazy worrying about the possibilities. But now something has happened, and it is time to take a look.
Territorial Control Largely Unchanged
But even though something has happened, it’s unclear exactly what that is. The primary fear was that Russian tanks would be smashing through Kyiv, the capital of Ukraine. The reality is that Russian troops are moving into areas already controlled by Ukraine’s Russian separatists. How many troops? We really don’t know. But they are entering territory already outside the control of the Ukrainian government. As of this writing, in terms of actual control of territory, nothing much has changed—yet. And that takes us back to what might happen as opposed to what is happening. The worst fears, so far, are unfounded.
Wall Street Worries
We can apply the same lens to the markets. Something has happened—the S&P 500 is down by 10 percent. But why? Is the Ukraine conflict the reason? Or is the decline due to something else? So far, it looks like Ukraine is not the reason for the drop, despite the fears. So, if that is the case, future damage to the markets from the Ukraine crisis, if any, should be limited.
But what has pulled the markets down, if not the Ukraine crisis? The most likely candidate—one which makes both fundamental and mathematical sense—is higher interest rates. The numbers work like this. Since the start of the year, the yield on the 10-Year U.S. Treasury is up from 1.63 percent to 1.97 percent. That’s an increase of 34 bps, or 21 percent. Higher rates typically mean lower valuations. And, currently, the forward price/earnings ratio for the S&P 500 has dropped from about 22.35 at the end of 2021 to an estimated 19.1, a decline of 3.25 or about 15 percent. After adjusting for earnings beats this quarter, that drop in valuations pretty much explains the drop in the market. And that rationale doesn’t leave much, if any, room for worries about Ukraine. Wall Street, then, seems to be much more worried about Fed Chairman Jay Powell than Vladimir Putin, at least at the moment.
Ukraine’s Impact on Markets
When we look at where stock valuations come from, that makes sense. Corporate earnings remain strong and are expected to stay that way. Valuations are determined by rates. And neither of these factors are directly exposed to Ukraine. Simply put, Ukraine is a small country and not a significant player in international markets. The direct impact on financial markets should be small, and that is what we are seeing.
Indirect Effects on Markets
We must still consider the possibility of indirect impacts from the Ukraine crisis, which likely will have an effect on the market. The price of oil is a big factor, as Russia is a major energy supplier, and we are already seeing the effects of higher oil prices. This situation will likely keep inflation higher than it would have been. And the effects will be worse in Europe than here, which will hit global growth and sales. These indirect effects are all real, and they could negatively affect the markets going forward.
If we consider the negative outlooks, we also need to consider the positives. As oil prices have risen, drilling in the U.S. is already picking up again. This factor will both constrain oil price rises and help economic growth here. If, however, growth does slow significantly, so will inflation. This scenario could slow down the Fed’s interest rate increases. It could also bring rates back down—to the benefit of stock valuations. And, at some point, there is a real possibility that the Russia-Ukraine crisis will pass. This outcome would leave us in a more stable situation with lower levels of fear, which would push economic growth and the markets back up. Bad things could and likely will happen, but so will good things, often as a direct result of the bad things. Either way, the impact on markets, over time, will be limited.
Make no mistake, though, things could get worse in the short term. Putin could decide to invade the rest of Ukraine, sanctions could be ramped up on Russia, and Europe could take a real hit. But all of these are only more extreme versions of what we are already seeing—and weathering. And the potential offsetting good effects only become stronger if the crisis gets worse.
The fear is that, somehow, the Russia-Ukraine crisis will sink the markets. But for that to happen, either earnings have to drop (which is not likely to any significant degree) or valuations will have to drop (which would be constrained over time). People could panic, but so far that has not happened. Even if some investors do panic, market panics pass. We have seen this happen several times during the pandemic.
Fundamentals Remain Strong
Market volatility is normal, but the truth is that the decline we have seen so far is much less than might have been expected. That is due to the strength of the fundamentals, which should continue. The U.S. economy continues to grow, our country remains open, and, even as the geopolitical worries ramp up, our medical worries are declining. Will the Ukraine crisis have an impact? It certainly will, on a geopolitical level. On an economic and market level, though, that impact is and will be much less.
That is the key takeaway here. This is a real crisis, but it is not about economics or markets. As such, the impact of the Russia-Ukraine conflict on your investments will be limited and likely short in duration, as we have seen with other crises.
Do we need to pay attention? Yes, we do, but thoughtfully. Personally, as a citizen, I am worried and monitoring the situation closely. But as an economist and investor, I am much less concerned. And that is a distinction to keep in mind going forward.