Just as small-cap stocks began to emerge from beneath the shadow of large- and mega-caps, a significant roadblock to the entire market’s near-term performance arrived in the form of U.S. military action in the Middle East.

In March’s webinar for the American Association of Individual Investors (AAII) and BetterInvesting, Charles Rotblut and I both agreed that a war tends to have a short-lived impact on the stock market, pressuring prices in the near-term but not holding back the upward march of equities over the long-term. In many cases, recovery from market declines that occur when war breaks out can be measured in days, weeks, or months, and certainly not years.

This conclusion comes from a review of past military conflicts which have had consistent but often surprisingly brief impacts on the US stock market. While the initial reaction to “shocks”—such as the bombing of Pearl Harbor or the 9/11 attacks—is almost always a sharp, emotional sell-off, markets have a high success rate of recovering to pre-conflict levels quite quickly.

In 20 major military conflicts since WWII, the S&P 500 fell an average of 6% from the start of the event to its bottom. On average, the market takes only 28 days to return to its pre-conflict level. One year after the onset of a major conflict, the S&P 500 is higher 70% of the time, with an average return in the high single digits.

The magnitude of the market’s reaction often depends on whether the conflict causes a “supply shock” (particularly in the energy sector) or occurs during an existing recession as with the 1973 bear market. 

Research from RBC Wealth Management and LPL Research indicates that the S&P 500’s reaction follows a predictable pattern.

First, war is usually a “known” risk. Markets hate uncertainty. Once a conflict begins, the uncertainty of whether it will happen is replaced by calculated risk. Investors begin modeling the economic impact, which often leads to a relief rally.

Secondly, military conflicts often lead to increased government spending, particularly as conflicts rage on. This fiscal stimulus can boost industrial and defense sectors, offsetting broader economic fears.

And thirdly, remember that long-term stock prices are driven by corporate earnings and interest rates. Unless a conflict fundamentally breaks the US economy or global supply chains (like the 1973 oil embargo), corporate America typically continues to generate profits.

Small company stocks have so far responded to the recent military operations as expected. The Russell 2000 (the popular faux small-cap stock index) promptly fell into correction territory in March, down more than 10% from its all-time high, while my preferred S&P SmallCap 600 index is still more than holding its own against the broader market.
 

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In this issue of the SmallCap Informer, we revisit a services company that we first profiled in 2021, and that has consistently expanded its top and bottom line regardless of broader economic conditions.

Stay the course!

— DOUG GERLACH

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