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The Art of Trading a War


I have traded markets through several conflicts, including the first gulf war. I can remember watching James Baker at the podium just after the last attempt at negotiating an agreement to avoid war. With his first word "Regretfully" not even fully out of his mouth (about the time "Re..." was out), futures began to drop precipitously.

This event can be compared to when UAL announced that their planned leveraged buy-out with employees was off. When that headline hit the tape, one of our biggest clients (I was trading at Morgan Stanley at the time) immediately called and yelled, "Sell something, anything, right now!"

This illustrates my conclusion about trading while our brave men and women are fighting for us: even though we have much emotion about it (my nephew is over there right now), as traders we must eliminate all emotion and treat war just like any other data point.

In both examples above, even though the initial move was correct, over time the markets stabilized. The news announcements caused high emotion that was eventually dispelled.

Since war produces a series of news and announcements, I view it as if it were earnings season. Each earnings announcement can be good or bad, just like announcements coming out of war. Each earnings announcement has a small effect, but it is really the culmination of the announcements, a culmination that indicates the "state" of profits in general that really matters. So first, we cannot get caught up in each announcement.

The one thing that does happen, however, is that just like in earnings season when there is more news to move the market, war, depending on the kind of series of announcements, will cause volatility to increase. I mentioned yesterday that actual volatility has increased while option prices really haven't. We have been buying some convexity as a result.

A war in the long run, I believe, will only have a long term effect on the stock market if it has a significant effect on the currency and bond markets. Interest rates are very important to stocks, probably the biggest fundamental factor (the biggest non-fundamental factor is the risk premium investors attach).

Unless a war affects the level of interest rates in the long run (or something even more significant like the existence of a government), it is important not to over-react to any one event or announcement. The culmination of war if significant can affect interest rates, the cost of money: higher and higher debt will raise interest rates.

I have said that the real bearish scenario (from fundamental factors like high debt and an over valued dollar) will unfold, if it does at all, and be reflected in the bond market first. War is no different.

We have seen rates rise fifty basis points over the last few weeks. This has been attributed first to the supposed improvement in employment and then a slightly higher CPI, but it has also coincided with some worsening news out of Iraq.

Since the dollar has risen as rates have risen, I would say that this occurrence cannot be attributed to the war. If the dollar begins to fall as rates rise, I would rethink that.

I am anything but callous about our soldiers fighting and dying for us and I honor them with all my heart, but I don't let it affect the way I trade.

But like always, I watch bonds.
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