Monday, February 19, 2007

Regional Risk: Conflict with Iran

Over the weekend I have been involved in an interesting private thread regarding regional risk in the Middle East, and what investors should do in regards to protecting their portfolio in the event of a flare up.

There have been a number of articles recently outlining the increasing tensions with Iran and sketching out scenarios in which armed conflict will occur. Some articles focused on the possibility of Israel attacking Iran to derail their nuclear ambitions, others the possibility of direct attack by the US. The immediate question for many investors is “what should I do to protect my portfolio from this type of regional risk?”

The short answer is that you should make NO changes in your long term investment plan. However several possible portfolio actions relevant to investors with short investment horizons and speculators will be explored below. Limited theater conflicts only have a fleeting impact on the stock market. Investors can expect the market to drop steeply for a short period of time as the conflict starts, and recover rapidly. This has occurred in similar situations such as when the war in Iraq started.

First some background

OPEC has been increasing production capability over the pass months. In event of conflict, the loss of 4M barrels of oil per day represented by Iran will certainly have an impact on the price at the pump. Oil prices would likely head to between $80 and $100 per barrel for a brief period of time, leading motorists to gripe about paying $3.75 for unleaded regular. However, with reserve capability available, oil producing nations would likely boost production to cover the shortfall within days of any international shortage occurring.

The economic reality is that beyond oil, Iran does not have significant representation in the world economy. Iran has a large population; many of the people are young and educated. Internal strife exists between conservative religious factions leading the government and a good portion of the more secular population.

However from an economic perspective, Iran exports limited commodities (beyond oil), technology, or manufactured goods. The Tehran stock market is insignificant from a global perspective, and the economy of the country is already in shambles.

One good article from ING Wholesale Banking that provides some background and investment perspectives can be found at:

What if I have a shorter investment horizon? - Stocks

Many will say “what if my investment horizon is shorter and I have a need to hedge my portfolio?” One example could be your child’s college portfolio when they are either already in college or shortly due to start paying big tuition bills.

If an investor is significantly concerned about conflict in the Middle East over the next six months, how can they hedge against transitory shocks to the stock portion of a portfolio with a short time horizon?

One immediate thought is to purchase put options on an index in order to hedge a short term loss. You need to look at these puts as an “insurance policy” rather then an investment. If a good portion of your portfolio is large Cap U.S. stocks then you should consider put options on the S&P index. SPY is the ETF that tracks the S&P 500 index and is optionable. Investors should consider put options that are 8% below the current SPY price of $145.73 and 6 months out of market. One possible contender is September SPY put options at $134 currently priced at $1.62

How should investors view these puts? They are an insurance policy rather then an investment. You should purchase the proper number of put options to protect your short-term portfolio against dramatic geo-political events. Basically you are paying a “premium”, just like your home insurance. Similar to your home insurance policy, you should count on the money spent on the put(s) being gone and just be glad that no fire occurred.

When should an investor sell these puts? Normally the market will tank when a conflict starts and then slowly recover over a timeframe of several months. In all likelihood, an “insurance investment” in puts should be sold immediately when a conflict starts and the market is in a panic. Take the proceeds and place them in cash or equivalent for the duration of the event. This will enable you to meet your ongoing short-term expenses for items such as college education.

What to do if the probability of the conflict appears to be reduced, for example Iran comes to a nuclear agreement with the UN to stop their weapons program. In this case, the investor should sell the puts (at a loss likely) while the options still have a time premium. In this manner, you would still be getting a portion of your “insurance payment” back.

Short-term Horizon: Bonds?

Many people will have a portion of a portfolio with a short investment horizon in bonds. If an investor is concerned about Middle East conflict then they should focus on Global high quality bond mutual funds. These funds will provide the necessary diversification and quality to protect your portfolio.

There are numerous funds focused on the high quality global income sector. One example is the Prudent Global Income – PSAFX. This Morningstar four star rated fund focuses on the short-term government bonds of safer nations and keeps a small portion of the investments in precious metals. The expense ratio of 1.28% is on par for other funds in the sector which is not correlated traditional U.S. bond funds, therefore considered more risky in the “bond sector”

Does this mean that an investor should rush out, and sell all their current bond holdings and rotate into this? No! However an investor should consider adding this type of protection to the bond component of their portfolio, or rotating a portion (1/3 or less) on their short-term investments dedicated to bonds into this type of high quality global income fund. The investor must keep in mind tax consequences. It should be noted that these global income funds also provide a hedge against the U.S. dollar dropping.

What if I want to speculate?

Well first…. good luck. The market is built around burning retail (non-professional) speculators. Keep in mind that the stock market is likely to tank at the advent of a conflict, and then recover, based on past behavior. Those who sell-short after a conflict starts expecting the market to tank further are likely to have their heads handed to them. You need to be positioned short prior to any missiles flying to have success playing the downside.

Despite the commentary in the ING article, an investor should likely not rush to buy oil companies such as Exxon. These companies would benefit from an increase in the price of oil, but this has to be balanced against the risk to their operations in the region. This risk in speculating on oil companies in an environment in which the overall market is tanking short-term outweighs the potential financial gains.

There are many reasons that the price of gold increases or decreases. Gold is likely to increase at the advent of any regional conflict. Retail investors can obtain easy portfolio access to gold via ETFs such as Streettracks GOLD TR (NYSE:GLD). It is probably better to purchase gold directly via an ETF then to purchase mining companies outlined by the ING article.

Commodities have been strong over the past few years; there is robust demand world-wide which will continue to make this area a growth market. In the event of a conflict, I expect that basic materials will go up in price, this diverges from the gist of the ING summary. In the futures market there will be upside in everything from copper to crops in the weeks after a conflict breaks out. Outside the futures market, speculators can take a look at using broad-based commodity index ETFs such as Deutsche Bank Commodity Index Tracking Fund (DBC) as a tool, or use more narrow ETFs to focus on particular sectors. Examples include PowerShares DB Agriculture Fund (DBA), PowerShares DB Base Metals Fund (DBB), PowerShares DB Energy Fund (DBE), PowerShares DB Precious Metals Fund (DBP), PowerShares DB Oil Fund (DBO), PowerShares DB Silver Fund (DBS) and PowerShares DB Gold Fund (DGL).

Thoughts on the currency and debt strategies outlined by ING

Generally, the currency and debt strategies outlined by ING Wholesale Banking are for professional traders and institutions. These strategies are generally not appropriate for standard investors and speculators. Even the outlined currency strategies would be difficult to implement with retail Forex firms without getting slaughtered by the spread in a quickly moving market.

Where I disagree with the ING article

A short-term spike in oil prices above $80 per barrel is very plausible in the event of conflict with Iran. The article believes this is unlikely. I concur that oil would likely settle between $65 to $80 per barrel, however we are very liable to see a several week price increase to the $80 to $100 range, primarily driven by market speculation rather the realities of supply and demand. Most banking articles tend to not properly take into account the speculation factor in the oil market during risk situations when arriving at pricing models.

In the debt market, I believe the “flight to quality” will involve investors dropping U.S. bonds and looking to European markets. With the current flat US yield curve, there is very little leeway in U.S. credit spreads and the likelihood of longer term bond yield rates dropping significantly for any period of time is minimal without a complete restruturing of the market. Keep in mind that the debt strategies outlined by ING would be very difficult for the average retail investor to implement.


The regional risk embodied by a conflict with Iran is very different then the situation in South America. The nationalization of economies in Latin America represents a change in long term trend, while armed conflict with Iran would be short-lived. This leads to the different requirements in investor response to these situations; the absolute need to trim exposure to emerging Latin American markets compared to the avoidance of altering your long-term investment plan in regards to the Middle East. In summary, an investor should make no changes to their long-term investment portfolio in reaction to a conflict in Iran. These type of clashes tend to have a short-lived impact on the market, and your portfolio should recover over the course of several weeks.

Disclosure: I own PSAFX and DBC in my portfolio.