Investing In Trouble

If there is to be trouble in the Middle East, as it appears likely now with the Iran situation, how do you go about investing over a period like this? Do you turn a blind eye to the danger and convince yourself that, like most things you worry about, it will never happen? Or do you go heavily short? Probably the wisest thing is to be mostly in cash until this elevated danger period resolves itself. If Israel doesn't do a strike over the next 3 to 6 months, they probably have decided to go the nuclear deterrence route and will simply wait for any future Iranian attack that might happen to justify a complete eradication of Iran as we know it. If they are going to preempt, even if conventional weapons are used on nuclear reactors, it would still be a nuclear war in the Middle East with radioactivity problems, unlike the relatively simple, sanitary strikes of the past. All good reasons to be in cash.

But if you must be exposed to the markets during this time, what do you hold? Well, you could look at how the markets reacted to the two big Middle East blow ups of the past - Saddam's Iraqi invasion of Kuwait on August 2, 1990 and the invasion of Iraq in March, 2003. These two episodes are similar in some ways to what an Israeli strike on Iran would be. In 1990, Iraq was the 4th strongest military force in the world behind only the U.S. Russia and China. It was not known if they would use bio and/or chemical weapons as they had just done in their war with Iran. And the fate of oil supply was anybody's guess. It was a scary military adventure. Iraq's military was much weaker in 2003, but Saddam still promised "the mother of all battles" when George Bush, Colin Powell, and the administration made their case before the U.N. for the invasion.

The two investment vehicles that come to mind for such things are gold and oil. This is how these behaved relative to the S&P 500: (click to enlarge images)


Both gold and oil were in bear markets in the early 90s and the general action was a strong climb for about 3 months and then a return to what they were doing before, which was their bear market. So unless you happened to know the timing of the attack, it was problematic to be a holder of gold or oil during this time. It was a different condition for the 2003 event:


Both gold and oil were in the early stages of their present bull market. It became obvious in late 2002 that there was going to be an invasion "at a time of our choosing" as Bush explained it to the world. So the reaction of gold and oil dated from late 2002 and was again a 3 month or so interruption of what they were doing before, which was a bull market. So it was not a problem to be holding these investments - they would do a climb with or without an attack.

That's pretty much the same situation we have with gold, oil, and Iran today. Gold in particular is probably going into a hypergrowth phase, according to the fractal analysis anyway, and falls into that nice category of "will climb with or without an attack". Oil is a little more of a problem because it is so sensitive to the economy. Trouble in the Middle East could put the fragile recovery back into a mark down of the price of oil. The threat of a Gulf tanker disruption could briefly spike oil, but that may be an erratic, unpredictable gyration depending on how successful they are at keeping the Gulf open (and that would be a major military project in any attack). The fabled horror scenario of a closed Gulf may not happen. But even if there is no oil shock to the economy, there may be a trade shock because Russia, China, and others are forming trade partnerships with Iran, which may come under severe strain if the U.S. is complicit in any attack.

There is an area of the markets that may be better than oil or even gold, and that is the military stocks. Aerospace/defense tends to run in cycles of about 7 years, and we are early in the next up phase. The arms stocks typically jump when any major global fight is picked. They reacted immediately as the market tanked after 9/11:


Raytheon's action was typical - a strong reaction at 9/11 when it was obvious that there was gonna be big trouble, and a more subdued reaction in late 2002 when the details became more clear. The 1990 action was similar. Even if fisticuffs don't break out between Israel and Iran, and Tehran is allowed to become a nuclear power, this development would cause all the nations in the region that had no real reason to spend heavily on high tech defense to begin doing so. It would instigate something of a regional arms race - very good for the arms makers. But this would be very bad for world peace - a Mutual Assured Destruction arms race in the Middle East with the fastest growing member a suicide bomber by religion. This is another major reason for preemption.

Another possible good investing area - the WMD stocks. When the coalition forces went into Iraq in 2003 and found no dreaded stockpiles, WMD went off the radar. But Iran has bio/chem weapons. They have been dramatically building up the stockpiles of rockets and other arms from Iran in Lebanon, and one such depot was disrupted recently with a release of some chemical weapons, killing several people. If Iran is attacked, the retaliation would likely include threats and possible use of WMD, refocusing attention on them similar to what 9/11 did. Many of the related stocks gained sharply:

Percent-wise, these stocks tended to out gun the gains in gold stocks or about anything else. Versar is typical of several such companies that are now in much better fundamental condition than they were in 2001. VSR has vastly stronger eps running a current PE at 13, price/sales at 0.4 and much improved cash flow. The cash flow dipped into the red a year ago, but is turning back up strongly with zero debt. I put this one into my fund at $3.80 mainly as part of an Iran lineup , but I'd be buying it even if all were peace and love in Iran.

There are ways to "invest" (or maybe we should call it profiteer) in trouble, but a high cash position is still wise. I'll be posting more on some military stocks I'm looking at.