Important points
Fog of war refers to a situation in which soldiers become disoriented during combat due to the lack of visibility of the entire battlefield and the rapid pace of combat, making it difficult for them to communicate with their units or even distinguish between friendly and enemy combatants. It can lead to poor and often fatal decisions. In rare cases, the investment environment can become foggy and the future uncertain. That’s where we are now. Investors should focus on three things right now: Assessing the risk of their portfolios Raising capital Waiting for clear positive developments regarding the war. The Iran war has created great uncertainty. Some of its effects are already apparent. Everyone is already seeing rising gas prices, but it’s not just oil production that’s being disrupted. Potential shortages of helium, aluminum, fertilizer, natural gas, and pharmaceuticals could impact the prices of new cars, cell phones, medicine, and even everyday staples. After several attempts to rebound this week, including one late Thursday due to casual comments from Israeli Prime Minister Benjamin Netanyahu, the S&P 500 ended with a fourth straight week of losses, and the Nasdaq Composite Index entered a nearly 10% correction. When prices rise for an extended period of time, they can lead to demand destruction, or a long-term decline in consumption, which often causes recessions. We are already seeing potential signs that base metals such as copper will fall significantly this week. @HG.1 YTD Mountain Copper Futures, YTD Fed Chairman Jerome Powell’s recent comments at the press conference following the Fed’s interest rate decision reflect this sentiment. The Chair acknowledged that there is uncertainty about how tariffs and rising oil prices will affect inflation and the direction of monetary policy. He urged investors to take the FOMC’s quarterly interest rate and economic outlook “with a grain of salt” as they “contain a high level of uncertainty.” Analysts at JPMorgan believe investors are pricing in “an early end to the Middle East conflict and the reopening of the Straits, which is unlikely to hurt underlying demand.” But investors should not only consider the most likely, or base case, scenario, but also the possibility of less likely, but more dire, scenarios. Israel’s attack on Iran’s South Pars gas field on Wednesday marked a significant escalation in the war. Not only would it extend the expected duration of the war and lead to retaliation (as already seen with Iran’s attack on Qatar’s Ras Laffan industrial city, the world’s largest liquefied natural gas export facility), but it was the first such attack on an upstream production asset, which could take much longer to repair than previous attacks on energy storage facilities. Significant damage to the Middle East’s energy infrastructure could take years to repair, even if hostilities quickly subside. Consider cash When volatility increases, investors are obligated to avoid leverage and consider raising cash. Cash can provide investors with a temporary safe haven and options if the market takes a dive. Some professional investors have already begun making adjustments. Fund managers’ cash balances rose to 4.3% from 3.4% last month, the sharpest increase since the coronavirus crash in March 2020, according to a Bank of America survey. After hovering near record lows, these levels are now closer to average levels. So the rush for cash may not be over yet. Analysts at Deutsche Bank suggested in a recent note that “long-term investors have not yet significantly changed their positions, so a continued shock could lead to an unwinding.” JPMorgan echoed this sentiment, saying, “Investors are mostly hedging rather than risk-averse, and gross leverage remains near highs (around the 95th percentile).” The longer the war lasts, the more likely such a shock will occur. In this case, time is no longer on the investor’s side. Investors now need to worry about weekend risks. Typically, if there are no major geopolitical developments over the weekend, markets tend to recover the following Monday. Three days of no news means three more days of significant supply imbalance. Focus on the ‘VIX’ The CBOE Volatility Index (VIX) helps investors understand the degree of market uncertainty. The median since 1990 has been about 17.6, but now it’s about 28. Values between 20 and 30 indicate that investors may be nervous about the future. Readings above 30 usually indicate that some type of panic is starting to occur. .VIX 1Y Mountain Cboe Volatility Index, 1 Year Investors seek higher returns for higher risks. This means that the multiple must shrink. The S&P 500 index currently trades at 20.5 times next 12-month earnings, but given the current uncertainty, many investors may not feel comfortable paying that multiple. JPMorgan lowered its year-end target for the S&P 500 index from 7,500 to 7,200, citing potential geopolitical overhang. Taking Advantage of a Market Rally While technically the market may be oversold and ripe for a rebound, any rebound that is not accompanied by news of tankers starting to pass through the Strait of Hormuz should be viewed as an opportunity to reduce equity risk or shift some exposure to sectors such as defense or oil and gas. The only development to clear the current fog is likely to be the resumption of normal shipping through the Channel. That would likely eliminate some of the most pessimistic scenarios for the stock market. Until then, investors with short time frames of months or years should consider risk at the forefront of their trading decisions.
