How Will a Geopolitical Crisis Impact the Stock Market

History can tell

The Russia-Ukraine conflict is on everybody's radar. While more and more investors are seeking safer investment assets to hedge the mounting geopolitical risk, the protracted warfare along with the inflation environment can still stress every investor out.

So how have geopolitical issues impacted the stock market historically?

Geopolitical risk tends to be limited and short-lived 

This is a chart listing major geopolitical events in history along with their impact on the S&P 500 index.

As we can see, S&P 500 index will plunge initially in reaction to geopolitical concerns, with the biggest drawdown being -19.8%. Yet the negative influence is pretty acceptable, being -5% on average.

The time it took for the market to bottom and recover is 22 and 47 days, respectively. While the initial downturn is a little disheartening, geopolitical issues won't have a lingering effect on stocks, with the market bottoming out within one month and recouping loss within two months.

Stocks are better than bonds, large-cap is better than small-cap stocks

The stock market will survive geopolitical issues generally and then generate a return for investors, but which category is better performing? Small-cap or large-cap?

This chart tells us that small-cap stocks will have a slightly better return on average than large-cap stocks during times of war, yet their risk level is well above that of large-cap stocks, with one being 20.1% and the other being 12.8%. Large-cap will generate positive returns with small fluctuation in all four wars listed above, while small-cap’s return is highly volatile, even being negative during Gulf War. Thus large-cap can tolerate geopolitical risk much better than small-cap.

It has also illustrated that stocks will outperform bonds during times of war. Bond is much safer than stock, and probably highly preferred by investors when warfare has begun. But history shows stock will weather the storm and produce a decent return.

How will stock react before, during, and after the war

Now that stocks won't likely collapse facing geopolitical concerns, how stocks will react before, during and after the war? A general principle should be learned first.  

Principle: Market will go down when uncertainty is growing.

Using this principle, a stock market reaction can be summed up into three phases.

Phase 1: Capitulation (Before the war)

This is the period before the war has started, featuring the continuous build-up of uncertainty in the stock market. No one knows when the war will begin, to what degree different interest parties will combat one another, what kind of sanctions will be imposed, and what the incurred repercussions are. How the scenario will play out is anyone's guess. In reaction to this trait of high uncertainty, the stock market will show signs of capitulation, with accelerating speed dipping down.

This implies that investors are withdrawing from stock investment and seeking safer assets to withstand possible geopolitical issues. The volatility of the market, which can be measured by the. VIX CBOE Volatility S&P 500 Index will hike up.

Phase 2: Consolidation (During the war)

This happens when geopolitical conflicts finally break out. It should be noted, though, that total uncertainty related to geopolitical risks will diminish despite the war is still underway. There are still a lot of factors that can add to the degree of uncertainty, such as how well different parties or countries negotiate with each other. However, the total uncertainty will gradually decline as the war continues. What will be reflected in the stock market is a period of consolidation with stock prices slowly edging up in zigzags. There will be a series of higher lows in the stock charts.

Phase 3: Culmination (After the war)

The stock market will plateau and crest the moment when the war ends peacefully since there's little uncertainty. Instead of swarming into the market, selling into strength should be recommended when stock prices are at the apex. When all dust has settled, the stock market will fall down from the high point as part of investors secure decent profits.

It should be noted that the Russia-Ukraine conflict happens in the environment of high inflation, with the possibility of the Fed raising several rounds of interest rates. The market reaction this time may not coincide with history. Still, empirical research should be done to give us insightful knowledge.