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The Gathering Storm: Iran's Election, Israel, & the Persian Showdown with the West On June 12th, millions of Iranians poured into mosques, schools, and other public buildings being used as polling stations to cast their vote for the next Iranian president. Even as the world attempted to downplay the election’s importance, Iran received an unprecedented 85 percent voter participation level. Despite this impressive turnout in a population of over 60 million, the votes were counted mere hours after the polling stations closed. In the early hours of June 13th, Iranian state television announced that incumbent president Mahmoud Ahmadinejad was the winner in a landslide. The official vote totals for president Ahmadinejad were listed at 62.63 percent versus only 33.75 percent for his main challenger, former prime minister Mir Hossein Mousavi. The other two candidates, cleric Mehdi Karroubi and former Revolutionary Guard commander Mohsen Rezai received only 2.58 percent of the vote combined. Even before the vote counts were finalized, opposition candidates were rejecting the results and claiming widespread manipulation and voter fraud. In the weeks that have followed the disputed election, millions of Iranians have taken to the streets in protest. Led by rhetoric from defeated candidates Mousavi and Karroubi, Iranian citizens of all ages have joined the protest rallies, chanting slogans like “Down with the dictator!” and “Mousavi get my vote back for me!” For several days after the election, the number of protesters was in the hundreds of thousands in every major city in Iran, and these protests represented the largest public challenge to the religious regime since the revolution in 1979. The Revolutionary Guard and their allies the Basij paramilitary sprang into immediate action, brutally repressing the crowds with batons, water hoses, tear gas, and in some cases, bullets. The death of one Iranian civilian, Neda Agha-Soltan, was captured on video on June 20th, and in the following days, Neda’s death was broadcast on every major news network around the world. Neda instantly became a martyr and a symbol of the resistance against the repressive regime. While there is significant evidence of manipulation in the Iranian election, unfortunately the time when this matter could be resolved within the government has come and gone. During the protests, there were rumors of an uprising both on the streets of Iran’s cities and in the backrooms of Iranian religious and secular politics. As time passes, it is becoming more and more clear that the government will retain its power, and the Iran that President Barack Obama will have to come to the negotiating table with will be led by President Ahmadinejad and Supreme Leader Ali Khamenei. This is the situation that President Obama no doubt expected from the beginning of the Iranian election season; however, certain aspects have changed. Even with the resistance quelled, the Iranian regime no doubt remains shaken. Supreme Leader Khamenei knows he came close to the end of his regime through international interference or through a coup d’état by military officers tired of being told to kill unarmed civilians. More importantly, President Obama now knows that his negotiations with Iran on their highly controversial nuclear enrichment programs have a very real time constraint from the Israelis. Before the election, it was well-assured that the Israelis would not strike until after President Obama had a chance to sit down with whomever the Iranian leaders would be an attempt to find a diplomatic solution. The election has come and gone, and with the same leaders in place in Iran it appears that the Israelis are not going to wait long for President Obama to attempt to pull off a diplomatic miracle. Many sources, both within and outside of Israel, are convinced that Israel plans to attack Iran’s nuclear facilities within the year, some believe as early as September. If Israel attacks Iran as many believe they will, Iran will most assuredly respond with a ballistic missile assault on Israel, most likely targeting the Jewish and civilian-rich cities of Tel Aviv or Haifa. At this point, Iran and Israel would be in a de-facto state of war that would probably play out similarly to Israel’s 2006 war with Hezbollah in Lebanon, with each side trading missile attacks until the United States and the world community are able to negotiate a cease-fire. Most experts believe that it is highly unlikely that the United States would become directly militarily involved in this conflict. However the question for investors has become: even if the U.S. does not invade or bomb Iran, what destabilizing influence would a war between Israel and oil-rich Iran have on the already stressed financial markets? In order to test the effects of exogenous political events occurring in the Middle East on various financial markets, there are two previous events that can be used as guides: the first Persian Gulf War and the Israel-Lebanon conflict of 2006. The first Gulf War is especially applicable to the situation in Iran because it involves a prolonged build-up before war for the market to adjust, like the current situation in Iran. In addition, the Gulf war was a relatively quick military campaign from a militarily superior country going against an oil-rich country, and the outcome of the war was known before the war even began. This is similar to a possible war between Iran and Israel because Israel is militarily superior to Iran. In addition, if at any point it looked like Israel was going to lose, the United States would step in and prevent Iran from “wiping Israel off the map” as president Ahmadinejad is fond of saying. Similar to Iraq in the 1990’s, Iran is a very oil-rich country. The Israeli-Lebanese conflict is less applicable because it had limited effects on financial markets in the United States, but it is useful for comparison because it was a surprise attack. Rogue Hezbollah agents started firing ballistic missiles at Northern Israel on July 12, 2006 without provocation, so the assumption is that the market had very little time to adjust, and one would expect to see big “headline shock” movements on the day of specific events. The analysis into the impact of these events focused on four markets. One of these markets is the bond market, as indicated by 10-Year Treasury yields, which represent a U.S. market movement towards risk aversion. Gold prices are also included to gauge international movement towards risk aversion. Oil is included due to the direct effect that a conflict in an oil-rich region is expected to have on the price of crude oil. Finally, the market’s movement back towards risk was measured by movement in the S&P 500 index. These analyses are subject to significant outside influence by other market events and therefore cannot be used to attempt to predict future movements in the market to any degree of magnitude. However, analysis of these markets during two isolated Middle Eastern events has yielded an interesting pattern that can be applied to the possible coming situation in Iran to gauge market direction and momentum. Wall Street executives have always said that the market predicts future events and prices them in ahead of time. While there is significant evidence that this is true, in these two exogenous situations, we still saw some market shocks on the day of significant events within the conflict. However, in the case of the Gulf War, these movements were in the opposite direction of the way one would expect them to move. On the day that the United States began its air campaign against Iraq (January 17, 1991) the S&P 500 index rose 3.7 percent, the price of gold fell 5.9 percent, and the price of oil plummeted 33 percent. All of those significant moves occurred in one day, and all seem to be going the opposite way of an expected move on a day when the United States goes to war. On the day when Iraq invaded Kuwait (August 2, 1990), there were moderately significant shocks in several markets as well. On August 2nd, the price of gold went up 2.7 percent, the S&P 500 index fell 3 percent over the course of two days, and the price of oil shot up 7.2 percent. These movements are going in the direction that one would expect them to go when there is political instability. So what, if any, conclusion can be drawn from these analyses? Given the numbers seen here, there does not seem to be a prevailing pattern. However, through closer analysis, a pattern does emerge. The pattern that emerges confirms the Wall Street “clairvoyance” theory, but only to a certain degree. In an isolated Middle Eastern incident where the outcome of the war is predetermined, the market does indeed have the ability to foresee and price in the next significant event to avoid big shocks. However, the Street is only capable of foreseeing and adjusting to the next event, not several events in the future. This is the reason why when Iraq invaded Kuwait, the movement was away from risk. The market was anticipating the coming war with Iraq, but not yet anticipating its victor. The price adjustment of this coming war began the day that Iraq invaded Kuwait and led all the way up until the day before the war. Over the five months between Iraqi invasion and the beginning of United States military intervention, oil prices rose 38.5 percent, S&P 500 index fell 10 percent, gold prices rose 5.8 percent, and 10-year Treasury yields fell 14.7 basis points. While some of these do not seem like significant moves, on the day when the war that the market had been adjusting to for five months finally broke out, these movements were undone in a matter of minutes. The reason for this is that the minute war finally broke out, the market instantly started adjusting to the next political event, which was the U.S. victory over the Iraqi army. Over the course of the five week military campaign in Iraq, the market continued adjusting for the predicted U.S. victory. A similar adjustment phenomenon took place during the Israel-Lebanon war in 2006. During the actual war, when one would assume uncertainty would be at its highest and investors would want to avoid risk, stocks rose 2.1 percent, gold prices fell 3.8 percent, and oil prices fell 1.9 percent. While at first glance this phenomenon appears irrational, the simple explanation is that the market was already pricing-in the inevitable Israeli victory and return to normalcy. The final insight that can be gained from the Israel-Lebanon conflict and the first Gulf War is the one that can be applied with the most confidence to the looming situation in Iran, and that is the net effect. Each of the previous momentum analyses had some exceptions, particularly in the 10-year Treasury rates. In these limited exceptions, movements from one period to the next would be either insignificant or would move nominally in the opposite direction from what was expected. However, the net effect of each of these events on the market as observed by an analysis of the change in oil prices, gold prices, stock prices, and bond yields from 1 month before the incident until 1 month after was virtually nothing. In both the 2006 conflict and the Persian Gulf War, once the conflict was over, all four markets rebounded close to pre-conflict levels within a month. After these conclusions are drawn, applying them to the current situation in Iran is a simple task. Right now, the threat of war between Iran and Israel is looming. It can be reasonably expected that the market is starting to price-in the possibility of war; however, they are not yet assuming an Israeli victory. Therefore, in the coming months, we can assume a drop in 10-year Treasury bond yields and S&P 500 index prices, and a rise in both oil prices and the price per ounce of gold as investors attempt to avoid risk. However, as soon as the war finally breaks out as many think it will, we can expect a quick and decisive turn in the market. The market will begin to price-in the inevitability of an Israeli victory over Iran just as it priced-in the inevitability of war, and thus we can expect investors to become less risk-averse. Finally, whenever this conflict does finally break out, it can be assured that barring any other significant market-moving events, all four of these markets and by extension the market itself will rebound to very close to pre-conflict levels within a month. So while the threat of a war between Iran and Israel is certainly ominous, the market will most likely react in a rational and predictable fashion and rebound quickly after peace is reestablished. Disclosure: Keith Hinton is an intern at Cavanaugh Capital Management, a registered investment advisor in Baltimore, MD. The opinions expressed here are Hinton’s own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this article represent a recommendation to buy or sell stocks. |
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