Middle East conflict could be a real market danger

by Michael Tarsala, CMT

No matter how well things are going in the markets, there can be hidden dangers.

The one potentially significant market threat that hasn’t fully hit investors’ radar — at least in my mind — is a possible military strike against Iran’s nuclear facilities by Israel. The latest suggests that pre-emptive strike is possible even before the US presidential election.

Military units from 25 nations are now practicing maneuvers in the Strait of Hormuz in an an unprecedented show of force. It is assumed by all those involved that Iran would likely retaliate against any attack by blockading the important strait, impeding the flow of oil out of the region.

So you have a band of countries either preparing for the worst or putting on a show of force. Or both. It’s hard to know. We have, of course, seen military buildups in the past that did not result in conflict.

What’s concerning with regard to the stock market, however, is that I don’t think that investors are pricing in much geopolitical risk. If we did see military conflict in the Middle East, I think it would be a shock, especially with the current level of market complacency.

Below is a chart of the S&P 500 in red, and the CBOE Volatility Index, the VIX, in blue.


Source: Yahoo Finance

A low VIX represents market complacency, as is pretty much the case right now. The low VIX does not necessarily mean that a downturn is imminent, even though the VIX was low just ahead of many of the past market downturns.

What it does mean is that the market may be more susceptible to shocks when the VIX is low. Put in a powerful negative catalyst, and you have potential for spiking volatility and falling stock prices.

With the markets still in strong rally mode, though, how do you prepare for events that may or may not happen? Are you really going to pull money from the markets in the midst of a rally backed by strong market breadth based on a geopolitical event that might not even occur?

If you’re really not comfortable riding out the markets no matter what, one potential solution is to seek a talented active manager that can tactically position some or all of your stock investments.

There are pros and cons to both active and passive investing, mind you.

Passive strategies can save you a lot of money in fees. That can be very meaningful over the long haul.

A good active manager, though, can lock in profits from individual winning positions along the way.

More importantly, a good active manager can take defensive action when necessary, and may outperform in market downturns.

It is often more important to outperform when the markets are heading lower. It’s just the way percentages work. Lose 30% of a $1 million portfolio during a rough patch, and it will take more than a 42% gain just to break even. With an average gain of 6% a year, that could take you more than six years just to get back to where you started.

Read this for background if you want a fairly straightforward look at the pros and cons of active versus passive investment management.

That same article has a bit of background on the concept of max drawdown, as well. It’s an under-followed performance measurement, and one that you help you find an investment manager with a track record of that has lost less than the market did in past bear markets.

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