North Korea: What Can It Do To Your Portfolio?

Edited Photo. Source: Flickr - Marco Verch

With North Korea rattling their sabres (aka ballistic missiles), I thought it would be interesting to look at the stock market's response to war.

Since North Korea is threatening Guam, a U.S. territory and significant military base, it seems likely the Kim is close to having, or already has, missiles capable of carrying nuclear warheads that distance.

Kim Jong Un has been threatening South Korea and Japan – both U.S. allies – for a long time now. But actually threatening a U.S. territory and military base is a substantial escalation.

The Psychology Factor

As you know, I believe psychology plays a big part of any human decision. Arguably the reason why things are being pushed closer to the brink now than before is representative of the minds of the parties involved.

The Kim – like his father – is only interested in holding onto power in his fragile country. This means portraying power to his people and convincing them of his god-like invincibility. But the rest of the world isn't under his total sphere of influence and certainly aren't fooled.

While the media likes to portray him as a sort of madman and loose cannon, I believe self-interest always prevails. I highly doubt a pampered, coddled shorty with platform shoes, a weird haircut, and hands softer than a chubby baby's leg is willing to dive into a war he knows he will lose. This is not Adolf Hitler breaking the Ribbentrop Pact, and definitely no William Wallace marching on the Crown.

The only way pudgy Kim goes to war is if he knows that China has his back: right now they don't. Kim is more like China's kid brother who constantly screws up and shames the family. The main reason you don't really want to get rid of him as your neighbour is because a least you can slap the kid brother around every now and then to keep him somewhat in line.

Even China has been publicly critical of Kim's actions lately. They recently voted with the UN to tighten up sanctions against North Korea and have reportedly been refusing North Korea imports. They've also been working on bringing him to a table to settle things down.

Of course, it doesn't help that the White House is occupied by a hothead who tweets and says stupid things like most breathe. When China is your only real lever over Kim, it would be wise if the President didn't publicly poke big brother on Twitter for failing to control the chubby kid.

I can't help but believe if Obama was still the President, or even *shudder* Hillary, this wouldn't be happening right now. But alas, the people spoke and got Trump. And for the last 70 years Americans have always liked a President that talks tough.

A Look At History

Let's look a the way the stock market responds to war stuff by picking a few important time periods: World War I, World War II, Korean War, Cuban Missile Crisis, Vietnam War, and Iraq '91. To measure the U.S. market, we are using the Dow Jones Industrial Average Index adjusted for inflation.

World War I (1914-1918)

The Great War was seen by most Americans to be a European problem. At this time, America had just a small army and was focused more on domestic issues than international ones. However, U.S. involvement increased throughout the war.

The U.S. profited greatly from World War I, selling convoys of supplies to the Allied Powers let by Britain. American factories were running full bore and stocks performed very well.

However, once U.S. entry into war started being considered, stocks fell. By the end of war in winter 1918, stocks had fallen nearly 50% from their peak. Through the entire war cycle, the market moved a lot but basically ended where it started.

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World War II (1939-1945)

The second War was again a mission of American avoidance. To be fair, the U.S. never liked Hitler's Germany and were still partial to Britain, but the last thing the people wanted was U.S. involvement in another European problem.

However, the market reacted very differently this time. I suspect it was in large part to Hitler's quick dominance of mainland Europe. In a matter of a year, Hitler controlled most of Europe to the Russian borders. Pearl Harbour and the subsequent Japanese romp over the Pacific was equally troubling. Right until the German Axis advances stalled, the market dropped.

However, in spring of 1942 the stock market – and the Allies – began to turn around. Right through the end of war the stock market rallied aggressively.

Between 1939 and early 1942, the Dow fell 45%. But from 1942 to fall 1945, the market climbed 75% recouping the losses earlier in the war. Again, the market changed a lot during the war, but finished right where it started.

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Korea (1950-1953)

The Korean War was an interesting conflict because, at this stage, the U.S. was the only real superpower on earth. Sure the U.S.S.R. came out of WW2 a powerful nation, but they were still licking their wounds after suffering huge losses in population and wealth during the war.

More importantly, the U.S. had an arsenal of nuclear weapons at this point and were not scared to let the world know their power. Meanwhile the U.S.S.R. has just barely finished testing their own bomb in 1949, but were not close to having a real deterrent to America's power.

With the backing of the other Allied nations, in the form of a UN led invasion, the U.S. was barely affected by the Korean War. It hardly pushed the capacity of their military or industrial power.

During the entire War, the Dow moved up. Even when it looked like the Korean peninsula might be lost (August/September 1950), the market shrugged it off easily. I think the market action demonstrated the real insignificance of the war to America's economy.

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Cuban Missile Crisis (1962)

I love the Cuban Missile Crisis for its example of extreme brinkmanship and the maximum stress it caused on the American public. People legitimately believed Armageddon was imminent.

Perhaps the only reason crisis was diverted was because two of the most clever men of their time held political office. Kennedy had been burned by his military advisors not too long before the Crisis. He took things very slow and was deliberate in his actions and message. Meanwhile Khrushchev himself was a shrewd tactician who held an important card: Berlin.

Already leading up to the Missile Crisis, the stock market was undergoing a correction (known as the Kennedy Slide of 1962). This was mostly due to market overvaluation and Kennedy starting a verbal war with steel producers over prices.

However, in October – after the market had started trending up from the June low – the market basically sat still during the Crisis. Following the crisis the market rallied nicely.

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Vietnam (1965-1975)

The Vietnam war had a long history and a really slow buildup, but in 1965 the U.S. started to commit substantial troop numbers to Vietnam. This escalated a peripheral conflict into a major war.

Several years later, in 1967, it increasingly became clear the U.S. was getting mired down in a war with no progress. This continued with slow troop withdrawals starting a few years later.

The war costed the U.S. at least $1 trillion in today's dollars – a huge sum. Also, more than 50,000 American troops were killed (plus several million South East Asians).

The Dow fell more than 60% in inflation-adjusted terms during the war. A substantial amount that is reflective of the wars financial cost and increasingly negative public impact. It was also accompanied by two recessions.

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Iraq (1990-1991)

This short war lasted just under a year. Interestingly the Gulf War coincided with a U.S. recession. The Gulf War was always viewed to be an easy win for the U.S. They had widespread international support and U.S. military might dwarfed that of Saddam Hussein's army.

Again, in this war the Dow dropped and rebounded so it ended roughly where it began.

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What Can We Expect?

Expect nothing. Realize there is no way to predict or get ahead of the market. We can only take what comes.

If there is a lesson from these conflicts it is simple: war and the stock market are largely unpredictable. There are too many factors that play into market valuations and war is just one other factor.

If this is all a "petite" Cuban Missile Crisis it will have no real impact on markets at all. Likewise, if it becomes a quick mop-up like Iraq, then all should be good.

However, if this turns into a full scale Vietnam it could be ugly. A 60% fall in the Dow starting today would put us at $8,800. All I can say is that trend investing would be very preferable to a "Lazy portfolio" in that situation.

I would say it's best to ignore the noise, stick to your investment plan that you have determined is best for your situation, and keep on saving money and building those accounts.

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