How stock markets react to war

Shortly after New Year 2022, all major U.S. stock indices began a slow but steady decline, entering correction territory (defined as a 10% decline from a previous high) as of February 2022. Much has been written about this latest stock market correction and the reasons behind it, including market overvaluation, looming interest rate hikes in response to inflation, and ongoing supply chain issues from the COVID-19 pandemic, among others.

As if those reasons were not enough, on February 24, 2022, Russia decided to invade Ukraine. War is once again happening in Europe, and after 3 weeks of intensive fighting, the outcome is still far from certain.

This war changed the geopolitical landscape of Europe in an instant. Ukraine is facing a humanitarian disaster. Western sanctions piled onto Russia, who finds itself increasingly isolated on the world stage. Russian assets became almost valueless overnight. American companies stopped doing business with Russia altogether, but face loss of revenue as a result. Cutting off Russian oil and natural gas exports have driven oil prices up globally. Stock markets continue to waver as a result of this geopolitical shock. How long can Ukraine hold on? How far will Putin go? What will China and NATO do? It’s easy to see why the entire world is on edge. Stock markets are often a barometer of public sentiment, and in this case, that sentiment is one of fear and uncertainty.

How does the stock market respond to geopolitical shocks?

In a widely-shared article published shortly before Russia invaded Ukraine, analysts from The Glenview Trust Company evaluated the effects of 29 previous geopolitical shocks and the stock market’s response 1 week, 1 month, 3 months, 6 months, and 1 year after the event.

Image from Bill Stone, Chief Investment Officer, Glenview Investment Co. Original article.

In looking at this list, I must admit that time certainly has a way of dulling things. There’s no objective way to rank events by the magnitude of shock, but many of these events were hugely consequential in world history. Despite that, the authors found that stock market reaction to geopolitical shocks are usually transient. In over 83% of the events, markets were positive after one year, and overall, markets averaged 12.3% gains in the year following the event.

Unfortunately, I could not find their exact methodology. They did not specify whether their results are index returns alone or total returns, nor did they specify whether they are using nominal returns or real returns. Finally, it is not clear to me how exactly they calculated their percentages. For example, are they using daily index values? Do the 1-year returns represent the change in index value 365 calendar days later?

For example, let’s take the Japanese attack on Pearl Harbor on Sunday, December 7, 1941. Note that because Pearl Harbor happened on a Sunday, markets were closed. The S&P 500 (at that time, the S&P 90) closed on Friday, December 5, 1941 (the last trading day before Pearl Harbor) at 9.32. At the end of the next trading week (Friday, December 12, 1941), the S&P 500 closed at 8.73. This represents a weekly loss of -6.33%, not the -2.7% shown in the table.

Regardless, I have no bones to pick with their analysis, and I agree with their overall message: we know that historically, the U.S. stock market has shrugged off all setbacks over time to reach new highs. Despite the uncertainty over Ukraine, we do know that this crisis, like all the others that came before it, will also end, hopefully sooner rather than later.

How does the United States going to war affect the stock market?

Geopolitical shocks aside, how does actual war affect the U.S. stock market? The United States is not currently at war with Russia. Although that possibility is still remote, it is almost certainly higher now than prior to Russia’s invasion of Ukraine. While the U.S. has been involved in many military operations of varying intensities since World War I, the major wars that we have fought in the last 100 years are World War II, the Korean War, the Vietnam War, the Gulf War, and the Iraq War. Putting aside the terrible human cost of war, let’s see how the S&P 500 performed during wartime:

As usual, the baseline historical performance of the S&P 500 is approximately 10% nominal annualized returns (CAGR) and 7% real annualized returns. Wartime market performance varied significantly depending on the conflict. Broadly speaking, U.S. entry into World War II marked the end of the Great Depression, and massive war spending spurred rapid economic growth. Vietnam era results were dragged down by the Nixon shock, end of Bretton Woods, and a multi-year economic recession in the early 1970’s. The Iraq War was notable for the U.S. housing bubble and global financial crisis. Outside of World War II, the S&P 500’s performance during wartime probably has very little to do with being at war, and has more to do with other economic factors during that time period.

Overall, if we look at the combined time period where the U.S. was directly involved in a major war (289 months), we see that the S&P 500’s performance during wartime, both nominal and real, is similar to its long-term historical average.

Obviously, a direct shooting war with Russia would be unprecedented, so market performance during prior conflicts may not be all that useful. We have never been at war with another nuclear power. Actual war with Russia may very well escalate into a conflict that has no historical parallels. I should note, however, that contrary to popular belief, nuclear powers have fought directly with each other. Most notably, India and Pakistan are both confirmed nuclear powers, and have engaged in decades-long low level armed conflict, although thus far this has not escalated beyond border skirmishes.

Conclusion

Despite the headlines, the U.S. stock market does not seem to care about geopolitical shocks or war, at least in the long-term. The current market correction is likely multifactorial and not driven by the war in Ukraine alone. It goes without saying, but passive investors should (and will) continue to do what they’ve always done: invest regularly, avoid trying to time the market, and just wait. In fact, market corrections often represent opportunities to buy assets at discounted prices, even though the short-term volatility can be alarming.

The S&P 500 experiences a correction approximately once every two years. The last stock market correction happened almost exactly two years ago, in February 2020, when COVID-19 first swept the world. Since World War II, the S&P 500 has experienced almost 30 corrections. Market corrections are just part and parcel of investing.

Of course, the range of outcomes for the current Ukraine conflict runs the gamut from truce between Ukraine and Russia all the way to the world escalating to nuclear war on the other. If the latter happens, then everything we’re doing here is moot, and this will be the one correction that the markets won’t recover from in our lifetime. In any case, I hope you enjoyed this article on how stock markets react to war and geopolitical shocks. Slava Ukraini!