Five implications of Iran strikes for U.S. stocks
Immediate reactions
In the wake of the U.S. and Israeli bombing of Iran, investors understandably wanted to know the immediate ramifications. So, I decided to take a step back to look at potential broader implications for the U.S. stock market. The bottom line is that barring a prolonged disruption of global oil supplies, the conflict is unlikely to end the 3.5-year cyclical bull market (I am referring to the one that really began after the end of rate hikes by the Fed in October of 2022) by itself. Instead, we added to the list of risks the market is facing heading into the middle of midterm years.
Kneejerk Reactions
If we take a moment and track all crisis events for decades, I was able to log 59 since 1907. The market has tended to decline during the event itself, by an average of 7.0% and a median of 3.0%. Once the crisis has passed, the market has recovered within a few months, on average. The exceptions have been when a crisis damages the economy, such as the Bear Sterns collapse in 2008 or Arab oil embargo in 1973. Assuming hostilities subside in the coming days or weeks, we would expect the market reaction to be similar to the majority of crisis events.
Getting a bit more recent, I took a look at a picture provided by Thomas Lee at FundStrat. This showed the most recent spate of conflicts with an exact picture of each going into the conflict and then coming out. This dovetails with the statistics above that were gathered from S&P Dow Jones Indexes.
Rekindling Inflation
Coming into this year, one of our concerns was that the market was vulnerable to the typical midterm year correction. I have been mentioning this almost every week. As I like to say, “What the market hates most is what it doesn’t know or can’t handicap.” Market declines, even ones as consistent as during Q2 – Q3 of midterm years, require a catalyst. The overwhelming fear is how the conflict could be a catalyst to sustained negativity by flipping otherwise bullish (strong economic) indicators bearish (into a reversal to the negative). An obvious candidate is inflation. The headline CPI, which unlike the Fed’s preferred inflation gauge includes energy prices, has been in a downward trajectory since August 2022. Hence, we consider disinflation as having been one of the primary drivers of the cyclical bull market. The good news for the bulls is that there is plenty of wiggle room for inflation to rise before our key inflation indicator turns bearish. The year/year change in the CPI sits 0.36% points below the six-month average. The CPI has to rise 0.6% points above the six-month average to trigger a bearish signal, leaving room for a short-term oil spike. Since oil tends to be the underbelly of almost all economic manufacturing, it tends to be a very heavily monitored gauge. You will notice in the chart below that oil prices have been on a decline until the beginning of this year and then began a slow and steady rise into this conflict and then spiked, as expected. Hence, the underlying component of many manufactured goods (oil) is exhibiting very inflationary price moves.
Fed Complexity
The market hates uncertainty, and a new Fed chair generates additional uncertainty. While the early days of some new Fed chairs have gone smoothly, in other cases, new chairs have faced crises. The average correction of 14.8% during the first six months implies that investors have sold first and asked questions later. Investors have expected a Warsh-led Fed to be dovish, at least when it comes to the fed funds rate early in his term. Assuming he is confirmed in the next few months, a protracted war in the Middle East could delay the next phase of the easing cycle. Once again, here is the action of the past 13 Fed Chair appointments.
Rotation Confusion
From a technical perspective, the defining characteristic of 2026 year-to-date is the rotation out of previous winners of large-cap tech stocks and into real economy Value stocks. Rotations and consolidations can be healthy in that they prevent the market from becoming too narrow for too long. If they go on for too long, however, they can morph into a topping process. In this week’s note I brought up a point of “over concentration” and the “law of large numbers.” This is where these narrow concentrations really present themselves. If there are only 7 companies that are controlling a massive amount of investment capital, is there really any room for more money to buy into them and for them to get larger still? This point is never really known till it presents itself. At the same time, is technology really negatively affected by this Middle East conflict? Maybe not directly, but by virtue of being major components of the US Equity indexes, as the indexes decline in the face of conflict, these companies almost have to decline as computers sell down holdings within the indexes.
Resilient Models
The final point is perhaps the most important. Despite the risks the conflict creates, the weight of the evidence is positive for U.S. stocks. In its latest monthly run. While credit spreads between Hi Yield debt and US Government debt is sure to widen with the intensity of the conflict, bonds become even less attractive. When money flees the equity markets it tends to find a home in what is construed as safety locations- Gold and US Treasuries. The price spikes that these see make them less attractive and the sell-off in equities could eventually present opportunity. Even in the face of extreme volatility, this is what relative strength analysis is showing across the financial universe:
Absolute models have seen modest deterioration due to market volatility but still seem to be leaning slightly positively. The only one of the eight major indicators tracked by Ned Davis Research team that is bearish is crude oil futures. More indicator deterioration is needed before a longer-term defensive posture could be adopted.
In Closing
We are going on 11 months now without anything I'd call a legitimate coordinated market sell off. Also, we are within the window of the calendar when things just seem to happen – Liberation Day (last April), COVID (first quarter of 2020), Russia/Ukraine war, collapse of Bear Stearns (the Great Financial Crisis), etc. While this guarantees nothing, it does make me take any potential breakdown in stocks even more seriously. I often provide historical similarities or tendencies. This doesn’t mean to look at these as hard and fast rules, but rather to simply respect that good times and bad times seem to congregate with great consistency.
At present, stocks- both US and Foreign have been quite strong for some time. Commodities in the form of Gold and Silver have had an incredibly strong period, Bonds are at very low rates and with a Fed that is still leaning towards easing short rates, longer-term bonds and Hi Yield bonds don’t appear to be very safe opportunities, and cash is currently not paying really much at all. What does this all mean? We are in a conflict, markets- all markets, are volatile. Stick with quality and try to avoid emotion-based decision making.
- Ken South, Tower 68 Financial Advisors, Newport Beach
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