Fundamental Analysis Indices Trampled Under Foot: Middle East Turmoil Adds to Market’s Woes

What effect does conflict and war have on the stockmarket? In this article we look at past wars/conflicts and examine what the future might be with the current conflict in the Middle East.
Maybe I should stop taking my two-week Nantucket trip each summer. Last year during our stay we were glued to the news over the London terrorist bombing, and this year it was Hezbollah's kidnapping of two Israeli soldiers, prompting the current fighting in the Middle East.​

There's a thought on Wall Street that investors should be
"buying when the cannons sound and selling when the trumpets sound."

When thinking about this view I harkened back to mid-March of 2003, when on the eve of the current Iraq war, Schwab's Investment Strategy Council (which I chair) made our first post-bear market move into bullish territory, moving to an overweight on U.S. equities. We didn't precisely nail the market's bottom, but we were pretty darn close at seven days later.

So, as I sat on vacation mulling world events I wondered whether the escalating violence in the Middle East may give the market an opportunity to bottom. We've been cautious on the markets for a while now, and I'd love to be writing that a significant low was put in place with last week's nearly 400-point rout (for the Dow Jones industrial average), but I think it's still premature to declare the correction a thing of the past. A short-term rally may be in the offing if bearishness reaches another extreme (certainly to be expected given last week's action), but there remain enough headwinds to keep us on the side of cash.

Protracted military conflicts
My friend and ISI strategist Jason Trennert put an interesting table out today highlighting the unsurprising relatively weak market action (average annual change) during periods of protracted military conflict.

Military Conflicts and Market Returns
ConflictStart and End DateEventS&P500
World War II12/7/1941
Pearl Harbour
V-J Day
% change 57.7
Av. annual % change 15.7
Korean War6/25/1950
N. Korea Invades S. Korea
Truce Signed
% Change 26.6
Av. annual % change 8.6
Vietnam Conflict8/7/1964
Gulf of Tonkin Resolution Signed
Fall of Saigon
% Change 6.6
Av. annual % change 0.6
Gulf War8/2/1990
Iraq invades Kuwait
Cease-fire Accepted
% Change 6.8
Av. annual % change 10
War on Terror9/11/2001
Twin Towers Attacked
Israel vs. Hezbollah Conflict
% Change 12.7
Av. annual % change 2.6

Source: ISI Group

Note that the table shows the War on Terror as inclusive of this latest turmoil, a view to which I subscribe.

Arab conflicts
And, courtesy of my friend Lazlo Birinyi, you can see the history of market and energy sector performance around Arab-specific conflicts:
Prior Arab-Israeli Conflicts: 1965-2006

StartEndConflictOperation SummaryS&P500

% change
Energy Sector

% change
6/5/19676/10/1967Six-Day WarFought between Israel and Egypt, Jordan, Iraq and Syria1.341.98
6/1/19688/7/1970War of AttritionLimited war between Egypt and Israel. Ended with cease-fire signed in 1970.-19.28-15.18
10/6/197310/26/1973Yom Kippur War1973 Arab-Israeli war between Israel and coalition of Arab nations led by Egypt and Syria.1.63-0.71
3/14/19783/21/1978LitaniIsrael invades southern Lebanon.0.382.48
6/6/19828/30/1982Lebanon WarIsrael defense forces invaded southern Lebanon in response to assassination attempt.10.97-7.74
7/25/19937/31/1993AccountabilityIsrael launches week-[long attack against Lebanon to strike directly at Hezbollah0.845.31
4/11/19964/27/1996Grapes of WrathSixteen-day military attack against Lebanon targeted at Hezbollah.1.491.20
9/28/200010/31/2000"October Riots"Violent riots in which main roads were blocked while banks and stores were set on fire.3.23-2.15
4/3/20025/10/2002Defensive ShieldIsrael enters cities and villages to root out terrorists.-3.62-6.76
5/18/20045/24/2004RainbowMilitary operation in Gaza Strip. Israel's aim was to clear terrorist infrastructure.0.52-0.54
9/30/200410/15/2004Days of PenitenceIsraeli operation in Gaza Strip to destroy launching sites of rockets.-2.001.29
6/28/2006 -Summer RainsIsrael mobilizes thousands of troops to suppress rocket attacks against its civilian population.0.451.97
7/12/2006-Current ConflictIsrael struck at Hezbollah in Lebanon in response to rocket attacks.--

Average Returns (ex 2006 conflicts) -0.41 -1.89

Source: Birinyi Associates, Inc

The real market story
Global turmoil aside, though, I continue to think the most significant market drivers are the economy, trends in inflation and interest rates, and the related drawdown of global liquidity. Some hope rests on Federal Reserve Chairman Ben Bernanke's semiannual monetary policy report to Congress on July 19. In advance of his statements, expectations for future rate hikes have eased, with fed funds futures showing the odds of an Aug. 8 hike falling from 90% three weeks ago to less than 65% today. Bernanke may indeed evidence the slowdown in the economy, but he may be hard-pressed to talk more dovish on inflation in light of continued upward pressure on core CPI.

And of course, it's not just the U.S. Federal Reserve about which the markets are worried. There have been 90 rate hikes globally, including Japan (finally) last Friday, with the Bank of Japan bumping rates up to 0.25% from 0%.

There's a reason for the phrase, "don't fight the Fed." Rate hikes hurt - they hurt consumers and they hurt business, and they could increasingly hurt earnings.

Bullish leg of earnings growth sprained?
One of the legs to the bullish case has been strong earnings growth. I don't dispute this, nor do I think earnings will falter significantly in the short -term, but looking under the hood is instructive. Less than 10% of the S&P 500's constituents have reported second-quarter earnings, but growth so far has remained strong, up 31% relative to last year's results and 6% higher than analysts' expectations, according to Thomson First Call.

However, the energy sector has been the big player in the earnings game over the past couple of years, and prospects for continued relative earnings outperformance are questionable. First, there's the simple math of more difficult earnings growth comparisons on the horizon given the stellar results historically. Then, there's the difficult relative first quarter the energy sector saw - falling short of its consensus earnings growth forecast by about 7%, the worst relative underperformance of all 10 Global Industry Classification Standard (GICS) sectors. (For comparison purposes, and remaining supportive of our underweight energy/overweight technology recommendation, the tech sector's earnings growth exceeded consensus expectations by over 20%.)

Energy's contribution to earnings tiring?
Here's the full rundown of first-quarter relative earnings growth performance compared to initial expected growth:
Technology +22%
Materials +19%
Consumer discretionary +11%
Industrials +10%
Financials +9%
Health care +7%
Consumer staples +4%
Utilities -2%
Telecom -7%
Energy -7%

Source: Thomson Financial

If this is a new trend developing, where earnings growth rates for the hottest sectors (energy and telecom) are underperforming expectations, we would expect a greater deceleration of overall S&P 500 earnings growth than is currently baked into the market cake.

Nasdaq under major pressure
Clearly not (yet) being helped by strong technology earnings results, the Nasdaq has gotten particularly bludgeoned of late. I turned to for some historical tendencies around this latest action. The Nasdaq closed last week with a 4.4% decline, trading at a 13-week low, and came within two points of trading below the lowest low over the past 52 weeks. What does history say about such weakness in the month of July?

Question: How has the Nasdaq performed in the past when it has lost more than 3.0% over the course of a week in July?

Answer: The index saw this event on 15 prior occasions since 1971. The Nasdaq continued to decline over the next six trading days in 13 of the 15 cases (87%) by an average of -3.5%. The average of the two rallies was +2.7%. The overall average return of all 15 cases was -2.7%.

The technical picture is clearly ugly, as is the global rate picture. Earnings growth remains healthy, but is coming under increasing pressure. The consumer is already under massive pressure with interest rates up and oil prices nearing $80 a barrel, and the bull market's long in the tooth. There's a race being fought currently, between rising inflation in the near term and faltering economic growth in the longer term. These races have been run before, typically causing financial accidents and a bit of market pain. The inverted yield curve heralds a potential recession. Throw more turmoil in the Middle East into the mix, and you have a recipe for continued market volatility. Cash is your friend.
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A clear look at the Mid East crisis from an economic angle
Holidays, Death and Profitunity Lord # "and I say to myself what A wonderful World"

"Maybe I should stop taking my two-week Nantucket trip each summer."

"So, as I sat on vacation mulling world events I wondered whether the escalating violence in the Middle East may give the market an opportunity to bottom"

hmmm well when I "mull" over Ak 47's and such being discharged into a fellow humans face etc, it kind of saddens me some, dont know why..hmmm somehow im not drawn to markets bottoming etc.....

tell us what were your thoughts when those planes with little children on flew into buildings..... did you have a good trade that day ? 9 eleven i think its known as. I was contemplating what those kids must of been thinking in their last minutes.

dow pop south through 9600 as I recall hmmm hope you piled in not a good time to be a buyin as others were a dyin, no that was a sell...

cool though, death = money is the saying maybe, covers both a long and short perspective maybe..

cheers Louis, nice one.