How Would a Major War Impact the US Stock Market?

CME: Micro S&P 500 ( MES1! ), CBOT: Micro Dow Jones ( MYM1! )
In the last two stories, I discussed how the prices of crude oil, a strategic energy commodity, and gold, a safe-haven asset, could soar at wartime.

Extended reading: “Would the Middle East Conflict Push Gold and Oil Prices Higher?”
https://www.tradingview.com/chart/CL1!/KKaL5b4u-Would-the-Middle-East-Conflict-Push-Gold-and-Oil-Prices-Higher/

Extended reading: “MCO: Options Strategy to Capture Crude Oil Volatility”
https://www.tradingview.com/chart/MCL1!/VfVpoutj-MCO-Options-Strategy-to-Capture-Crude-Oil-Volatility/

Today, I turn my focus on the U.S. stock market. The following analysis attempts to address this hypothetical question: How would US stocks be impacted by a major war?

While the media constantly blasts breaking news from the Middle East, the US stock market behaves like business as usual.
• On Friday October 6th, Dow Jones settled at 33,408. On the Monday after the conflict started, the Dow rose 197 points, or +0.6%, to 33,605.
• 1-week change: Dow closed at 33,670 on October 13th, up 0.8%.
• 2-week change: Dow closed at 33,127 on October 20th, down -0.8%.
• The S&P 500 had a similar price trend. It settled on 4,308 right before the conflict. Price changes were: +0.6% (1-day), +1.5% (1-week), and -2.0% (2-week).

What drive the US stock market are still corporate earnings and the Fed:
• In the first half of October, strong Q3 earnings season drove stock indexes up;
• On October 12th, higher-than-expected US CPI data pushed market indexes down;
• October 18th, stock market plunged after the Fed Chair delivered a hawkish speech;
• October 19th, Tesla’s Q3 underperformance led the decline of the broad market. All three US market indexes ended with a weekly loss.

Time is too young to tell anything about the current conflict. How about the Russia-Ukraine conflict? US stocks were on a downtrend all last year. But I would argue that this was driven by the Fed rate hikes, which pushed interest rates up 525 basis points.

Neither the Mideast nor East Europe saw US direct military involvements. Sending billions of dollars in aids to allies may raise federal budget deficit, but it is not likely to have a material impact on earnings for many of the US companies.

To fully assess the impact of a major war, we need to find one where millions of US troops were sent to the front line. This analysis examines how the Dow index responded to the two World Wars, the Korean War, and the Vietnam War.

World War I (July 1914 to November 1918)
• Phase I: In 1913-14, the U.S. suffered a two-year recession. According to the National Bureau of Economic Research (NBER), U.S. GDP dropped by 25.9%. The Dow fell from 68 points in September 1912 to 52 points in July 1914, down 24%.
• Phase II: The Great World helped end the recession. In the first two years, the U.S. remained neutral. American companies supplied vast quantities of arms and logistic materials to the warring countries in Europe. The Dow gained 106 points, up+104%.
• Phase III: The U.S. declares war on Germany on April 6, 1917. The U.S. military grew from 128,000 to 4 million soldiers. Initially, entering the war produced a shock to the U.S. economy. The Dow fell to 72 points (-32%). However, wartime production helped companies expanded quickly. By October 1918, the Dow rebounded to 86, up 19%.
• Phase IV: After the war ended, U.S. companies actively helped Europe rebuild. The Dow rose 118 points by October 1919, up 37%.

Commentary: WW1 was mainly fought on European soil. Whether as wartime suppliers for Europe or as government contractors, U.S. companies saw expanded production and higher earnings. At the end of the war, the U.S. overtook Great Britain as the No. 1 World Power. The Dow index rose 127% throughout WW1.

World War 2 (September 1939 to August 1945)
• Phase I: In 1937-38, the U.S. experienced a major recession, with GDP falling by 18.2%, according to the NBER. The Dow went from 188 in February 1937 to 98 points in March 1938, down 48%. A year before the outbreak of WW2, U.S. economy was in a slow recovery. The Dow grew to 135 points in August 1939, up 38%.
• Phase II: Germany started WW2 by invading Poland in 1939. Like in WW1, the U.S. remained neutral for two years and acted as a wartime supplier. As the Axis power threatened the very existence of the Free World, both Wall Street and Main Street went into a panic. The Dow closed at 111 points in November 1941, down 26%.
• Phase III: Japan attacked Pearl Harbor on December 7, 1941. President Roosevelt declared war and joined the Allies. The U.S. military expanded from 330,000 to 16 million troops. Once again, U.S. manufacturers transformed into wartime production. Huge government orders helped them grow rapidly. By September 1945, the Dow rebounded to 180 points, a 62% gain.
• Phase IV: The Marshall Plan made the U.S. a major force in rebuilding Europe after the war. U.S. companies benefited from these massive construction efforts. The Dow continued to rise, reaching 212 points, up 18%, by May 1946.

Commentary: From a purely economic point of view, U.S. companies saw rapid growth in production scale, revenue, and profit during wartime. After the war, the U.S. consolidated its position as the No. 1 World Superpower. The Dow rose 57% throughout WW2.

Korean War and Vietnam War
• The Korean War lasted three years from its outbreak on June 25, 1950, to the signing of the armistice on July 27, 1953. The size of the U.S. military was as high as 6.8 million troops during this period. About 480,000 fought in Korea.
• The Dow went from 210 to 277 points during the war, up 32%.
• Vietnam War lasted 10 years from March 1965 to April 1975. The U.S. military stood at 8.7 million troops. About 2.7 million soldiers fought in Vietnam.
• The Dow was 900 in 1965 and ended at 815 ten years later, down 9%.

Commentary: In WW2, the U.S. sent 3 million troops to Europe and 1.8 million soldiers to the Pacific theater. For a comparison, the Korean War had about one-tenth of the fighting forces. It did not have a big impact on the U.S. economy and the stock market.

Troops size in Vietnam was five times bigger. However, in this decade-long war, the stock market was influenced by many other factors, from the Civil Right movement to the Space Race; and from Nixon's historic visit to China to his resignation from the presidency.

Hedging with Micro Dow and Micro S&P Index Futures
In conclusion, my analysis shows that wars did not have a negative impact on U.S. stock market. Contradicting our intuition, U.S. stock market indexes generally rose during a major war and continued to go up after the war. Why is this the case?

All the wars we examined here were fought outside of the U.S. soil. In fact, no war has been fought in continental U.S. since the Civil War, for nearly 160 years.

Even in the two World Wars, the U.S. did not pay the heavy toll of civilian casualty and property destruction most warring countries suffered. Furthermore, the U.S. government has been a “going concern” and the U.S. stock market operate at peace time and in wars. You can’t say the same for Germany, France, Italy, Russia, the Austria-Hungarian Empire, the Ottoman Empire, the Japan Empire, or China.

With two reginal military conflicts fighting simultaneously, the risk of a global conflict increases exponentially. For a rational investor, this is a good time to plan for global asset allocation.

Those investors holding assets in foreign countries could consider hedging with U.S. stock market index futures. Whenever the next major geopolitical crisis break outs, assets in foreign markets and in foreign currencies may decline in value faster than that of the U.S. stocks. In the cases we illustrated, U.S. stock index could rise during wartime.

CBOT Micro Dow Futures ( MYM ) is notional on $0.50 times the DJIX index. At Friday closing price of 33,222, each December contract MYMZ3 is value at $16,611. Each long or short futures contract requires an initial margin of $800.

CME Micro S&P Futures ( MES ) is notional on $5 times the S&P 500 index. At Friday closing price of 4,244.75, each December contract MESZ3 is value at $21,223.75. Holding one contract requires an initial margin of $1,120.

Investors could consider a “Buy and Hold” strategy for as long as they hold assets that are weaker and/or less safe than the US stocks. For futures hedging, this strategy entails buying the most liquid nearby contract, holding it until contract expiration month, and then rolling it over to the next liquid contract.

Both MYMZ3 and MESZ3 expire on December 15th, the third Friday. By one or two weeks before the expiration, investors could close out the open positions and buy the March 2024 contracts, which are MYMH4 and MESH4, respectively.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/