The best way to respond to a geopolitical crisis

Mint

4 days ago

There's a better way for investors to respond to geopolitical crises, such as war and military conflict.
The conventional advice is to increase equity exposure immediately after a crisis erupts, since the stock market following past crises was, on average, higher in three, six, and 12 months' time. While this advice isn't bad as far as it goes, a new study finds that investors could improve performance by increasing equity exposure before a crisis erupts but as the risk of a crisis grows.
The study, titled 'The Pricing of Geopolitical Tensions Over a Century," began circulating in academic circles in March. Its authors are Andrei Gonçalves, Alessandro Melone, and Andrea Ricciardi of Ohio State University's Fisher College of Business.
It might seem counterintuitive to respond to increased geopolitical risks by becoming more invested, since the stock market almost always responds to such risks by falling. But it makes theoretical sense to respond by increasing your equity exposure, Gonçalves and Melone tell Barron's, since by the time you know that risks have risen, the stock market will have already declined. By then, it's too late to decrease your exposure.
Even if it weren't too late, however, they say the better response is to increase your exposure. That's because the stock market's immediate decline is its way of providing a higher expected future return to compensate investors for the greater risk. Increasing your equity exposure in response to a rising threat should therefore produce a higher return over the long term.
This is exactly what the researchers found. They were able to quantify geopolitical threats by relying on an index created a few years ago by two economists at the Federal Reserve: Dario Caldara and Matteo Iacoviello. Their Geopolitical Threats Index, or GPT, data for which extends back over a century, was compiled by measuring the number of articles in major newspapers that mention any of a wide range of geopolitical threats.
Gonçalves and Melone point out that the GPT in recent years has been highly correlated with surveys of fund managers' subjective assessments of geopolitical risk. They are therefore confident that the index's historical readings accurately reflected the geopolitical risk that investors perceived at any given time.
To illustrate the profit potential of increasing equity exposure in line with the GPT, the researchers constructed a hypothetical portfolio whose baseline allocation was 60% invested in U.S. equities and 40% in long-term U.S. Treasuries. This portfolio increased its equity allocation (and reduced its bond allocation) whenever the GPT rose above its historical median. From 1930 until the end of April, this portfolio's return was 1.5 annualized percentage points above another portfolio that constantly maintained a 60% stock/40% bond allocation. It outperformed on a risk-adjusted basis, as well.
You would have performed significantly worse if you increased your exposure only after geopolitical threats manifested themselves as actual crises—after war broke out, for example. That's because geopolitical risks don't always turn into actual crises, and you leave money on the table if you don't become more heavily invested in response to rising threat levels. 'In an era of global tensions, it's not just the wars we fight but the threats we fear that drive financial markets," Gonçalves and Melone explain.
The implication of this new study is that you should currently be moderately overweight relative to your target equity allocation, since, as you can see from the accompanying chart, the GPT's latest reading is moderately above its four-decade median. You could increase your equity exposure by investing in a broad market index fund, but a more targeted approach would be to invest in those industries that historically have been most sensitive to geopolitical risks. Two that the researchers single out, based on various industries' reactions to the Russia-Ukraine conflict, are Oil & Natural Gas and Autos & Trucks.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [e-mail].