Edwin Starr's classic 1969 anti-war song, War, asks: "War: What is it good for?" and responds emphatically "absolutely nothing." It's hard to argue with the sentiment. But it turns out Starr was not completely correct. You see, despite the terrifying carnage and destruction, war can often be a fruitful time to invest.

Let me be clear: I detest armed conflict. War should be avoided at all times and not prompted by immature despots, seeking acclaim they can only take to their grave.

With Russia and the Ukraine on the brink of war, and with markets predictably reacting negatively, I thought it is worth revisiting the enquiries I made the last time an armed conflict threatened to destabilise the world and markets.

History suggests past conflicts have not inflicted permanent pain on investors. It has indeed been wise, historically, to invest at the depths of the conflict when fear was at its extreme.

Research by LPL Financial, conducted in 2020, of market reactions to past geopolitical crises confirms stock market investors have mostly shrugged off geopolitical conflicts as some sectors and companies have continued to generate profits.

Of course, that latter observation doesn't let investors off the hook because stocks can, and frequently do, move independently of the performance of the underlying business.

Table 1, from 2020 by LPL Financial reveals however investors would be wise not to sell into the fear and weakness but instead, remember that there have been dozens, if not hundreds, of conflicts in the past and the stock market has survived. This of course is not to diminish the very real suffering at the hands of tyrants and dictators, which democratic allies should pull all stops to prevent.

Table 1.  A summary of geopolitical events and stock market reactions

Source: LPL Research, S&P Dow Jones Index, CFRA. 1/6/20

Let's put the current invasion of Eastern Ukraine by Russia into some perspective.

Following the outbreak of World War I in 1914, the Dow Jones declined almost a third within six months. Business ground to a halt and liquidity in the stock market vaporised as foreign investors sold US stocks to raise money for the war effort. The NYSE (New York Stock Exchange) closed on July 31, 1914. The world's financial markets closed their doors by August 1. The NYSE was closed for four months. It was the longest suspension of trading, and circuit breaker, in history. Almost immediately, however, a substitute trading forum called the New Street market emerged and trading began offering economically meaningful liquidity but impaired price transparency.

Closing the stock exchange for a third of a year would be unthinkable today. It was unthinkable then. To wit: "If at any time up to July, 1914, any Wall Street man had asserted that the stock exchange could be kept closed continually for four and one-half months he would have been laughed to scorn."[1]

It must have seemed grim for stock market investors, especially for anyone with capital tied up and locked down.

After the stock market reopened in 1915, however, the Dow Jones rose more than 88 per cent. 1915 recorded the highest annual return on record for the Dow Jones Industrial Average.

From the start of World War I in 1914, until its end in 1918, the Dow Jones rose 43 per cent or about 8.7 per cent annually.

The Second World War must have seemed primed to be a whole lot worse.

From the start of WWII in September 1939, when Hitler invaded Poland, until it ended in late 1945, the Dow Jones rose 50 per cent - equivalent to a compounded seven per cent per annum.

In other words, the two most damaging conflicts in history saw the stock market rise meaningfully.

On 7 December 1941, when the Imperial Japanese Navy Air Service attacked the U.S. naval base at Pearl Harbor, Honolulu, by surprise, stocks opened the following Monday down 2.9 per cent, but it took just a month to regain those losses. And then, when the allied forces invaded France on D-Day on June 6, 1944, the Dow Jones barely reacted and rose more than five per cent over the subsequent month.

Caveat(s)

According to research conducted in 2015, into U.S. military conflicts after World War II by the Swiss Finance Institute, stock prices tend to decline in the pre-war phase and recover when war commences. But when war is a complete surprise, stocks decline.

Another study, published in 2013 by Mark Armbruster, of Armbruster Capital Management, examined the period from 1926 through July 2013 and found that stock market volatility was actually lower during periods of war.

"We looked at returns and volatility leading up to and during World War II, the Korean War, the Vietnam War, and the Gulf War. We opted to exclude the Iraq War from this group, as the Iraq War included a major economic boom, and subsequent bust, that had very little do with the nation's involvement in a war.

"As the table below [Table 2.] shows, war does not necessarily imply lackluster returns for Domestic stocks. Quite the contrary, stocks have outperformed their long-term averages during wars. On the other hand, bonds, usually a safe harbor during tumultuous times, have performed below their historic averages during periods of war."

Table 2. Capital market performance at times of war

Source: Mark Armbruster/CFA Institute

In recent years, the 9/11 attacks and the Global Financial Crisis in particular, have trained investors to expect central banks to rescue them through the repression of financial market volatility. Moreover, the belief and hope the initial conflict doesn't escalate, drawing in the rest of the world, has also been supported by real world experience.

Investors have thus been conditioned to eschew an overreaction.

It is probably the fear of an all-inclusive war that inspires investor reaction to even the most minor of conflicts involving powerful nations but investors do well more often than not, when they remain invested, take advantage of weak prices and correctly bet that sober hearts and minds will prevail.

Most of the time it is economic and idiosyncratic fundamental factors that impact security prices. Very rarely, a solitary exogenous event is influential enough to override the usual factors and impact market returns materially.

Based on research of history and the above data, however, war and geopolitical conflicts shouldn't be counted in that category.

Author:  Roger Montgomery, Chairman and Chief Investment Officer

Responding to cannon fire in the bay, the citizens of Melbourne armed themselves and gathered in Port Melbourne in September 1854, believing a Russian attack that media commentators had warned of was upon them.

Twenty eight years later, Melbourne's Age newspaper warned that "it would be comparatively easy for Russia to bring down an overwhelming force from the neighborhood of the Amoor without awakening the suspicions of the British naval officers at China or Japan." The city's populace was then stirred by a series of articles claiming to have proof of a planned invasion - allegedly deciphered copies of telegrams between the Russian Minister of Marine and a Russian Admiral.

But the cannon fire in 1854 was actually from a friendly ship, the Great Britain, that was celebrating its release from quarantine. And the telegrams of 1882 and stories of imminent invasion that surrounded them were a hoax. No invasion obviously ever eventuated. The Ballarat Courier described it as a "stupid and offensive affair".

Melbournians (or a portion of them) had taken what they read in the newspapers at face value. They may have considered newspapers to be a trustworthy source. Gold had been discovered and wealth created that others might be envious of. There was a feeling of isolation given the distance from Great Britain. Russian ships had visited Victoria as they followed the winds on a "great circle" route to get from Europe to the northeastern region of their vast country.

Information fragments

The tragic war that is being waged in Ukraine is generating volumes of information and disinformation around the clock. It is far easier now in the social media era than it was in the 1850s for investors to be exposed to incomplete fragments of the truth or deliberately misleading information that causes their imagination ro run away and make decisions hastily.

This Ukraine war triggered panic when Russia attacked a Ukrainian nuclear power plant, Zaporizhzhia, which is understood to be the largest nuclear power plant in Europe. Images of heavy fire led to fears there would be a melt-down on a scale greater than Chernobyl.

Not to underplay the potential risks of what is going on in Ukraine, the reality was in this case that it was a training building at the power plant that caught fire, not the nuclear reactors. And the experts tell us, with reference here to Bloomberg's reporting, that the reactors are "housed inside containment buildings that will protect them from plane crashes, tornadoes, bomb attacks, and explosions caused by the escape of flammable fission by-products".

Learning from Historians as well as from History

Students of history (the tales of Melbourne's Russian fears are sourced from this investor's long forgotten Honours Thesis in History) need to know how to research and dig for relevant information. But that is only half the battle. Historians must also be able to critically assess information. Who or what is the source? What was the intended audience? What motives and bias come into play?

These skills are equally valuable to investors awash in live feeds from around the world - especially when a social media algorithm may be pushing one particular blinkered view or perspective on them.

Author: Martin Pretty, Director 

Roger reveals the past market performance following major geopolitical or historical events since World War II. A discussion on the economic implications invariably begins with energy markets. Booming logistics has created an energy crisis driving oil, from negative prices just under two years ago, to nearly a hundred dollars a barrel today.  Commodities prices have also soared with Ukraine one of the world's larger exporters of iron ore.

Transcript

Roger Montgomery:

A week or so ago we wrote about historical precedents with respect to the equity market returns amid war.

The summary; equities tend to decline in the prelude to war and rise when the first shots are fired. When we have seen divergence from that historical pattern it is because there was no prelude.

Between 1914 and 1918, the period that defines WWI and between 1939 and 1945 - defining WWII - the Dow Jones rose 8.7 per cent and 7 per cent per annum respectively.  During the two periods that arguably define the worst military conflicts in modern history the markets rose.

Most-conflicts-since-then have been relatively short-lived. Have a look at this table courtesy of LPL Financial. It reveals past market performance following major geopolitical or historical events since WWII. The bottom line is, in the absence of a recession, the market appears to eventually shrug off conflict.

None of this is to diminish the very real horror of the humanitarian crisis unfolding in the Ukraine, the mounting loss of life and thousands of families and individuals displaced as they leave their homes and relationships for safety across the border.

For each conflict or crisis, investor uncertainty stems from the presence of elements that make it more unique (and worse) than those that preceded it.

With respect to Russia's unprovoked invasion of the Ukraine, we have, according to various press reports, an unhinged kleptocrat, with a finger on a phalanx of nuclear weapons.

Maybe this time is indeed different. And let's not forget investors were already nervous about inflation and rising interest rate before Putin's aggression.

Indeed, the prevailing inflationary climate may have had something to do with his timing. Booming logistics has created an energy crisis driving oil, from negative prices just under two years ago, to nearly a hundred dollars a barrel today. Commodities prices have also soared. US inflation hit a four-decade high and perhaps, Putin seized the opportunity thinking the west might be loath to impose sanctions that drive prices higher.

But the Ukraine is one of the world's larger exporters of iron ore and some 600 million people in Europe and elsewhere are fed by the country's agriculture sector.

Conceivably, Putin underestimated the West's determination to secure this important source of food and mineral commodities. But more important than letting commodity supply fall under Putin's control, maybe it is the West's determination to defend democracy that Putin has underestimated.

Keep in mind, the stock market can remain elevated for some time - even as a train wreck is obviously approaching. Eventually however it succumbs to a wave of panicked selling - much as a deer or rabbit transfixed by headlights succumbs to the vehicle careening towards it.

Investors need to watch for the point at which the Allied's words, sanctions and the supply of arms to Ukrainian civilians is inadequate to defend democracy and the Ukraine.

Putin's persistence - and it is clear his pride won't tolerate anything less - and the failure of diplomacy, would be negative for risk assets. A consequent delaying, by central banks, however, of both quantitative tapering and interest rate increases is a positive.

If diplomacy does succeed, the focus will return to inflation, interest rates and the risk of a wage price spiral.

In either case the possibility of a pronounced correction is one investors should be ready to take advantage of. If I was to make one prediction it is that in a several years' time, we will have seen a correction but we will also have seen peak inflation and the effect of automation on productivity and wages, which will be incredibly positive for high quality businesses, those with pricing power and those growing into their-potential-to-be-a-multiple-of-their-current-size.

Speaker:  Roger Montgomery, Chairman and Chief Investment Officer