US Strike against North Korea Could Drop Markets 10%

08/14/2017 2:59 am EST

Focus: STRATEGIES

Don Kaufman

Co-Founder, TheoTrade

If the U.S. launches a preemptive strike on North Korea, I think stocks will fall about 10%. I also give that a 10% chance of occurring. With this new chance creeping into the market, stocks sold off, asserts Don Kaufman, Co-Founder of TheoTrade.


Get Trading Insights, MoneyShow’s free trading newsletter »


The geopolitical issues between the United States and North Korea appear to be one of the biggest risks facing the market in the next few weeks as earnings and economic reports look great. Friday the stock market responded to that threat by selling off. The Dow (DJI) was down 205 points which is 0.93%. The S&P 500 (SPX) fell 1.45% and the Nasdaq fell 2.13%. The CBOE Volatility Index (VIX) was up 44.37% to 16.04. The potential for volatility in the stock market was initiated when Trump promised “fire and fury” to North Korea if it threatened America again--and it did.

Let’s review the possibilities of this issue to see where the stock market can go.

The volatility beast has been awakened after being dormant this summer. Previously, I said stocks would fall 10% if North Korea acted on its threat to attack Guam. Giving that a 10% chance, I said stocks would fall 1%.

We must add a separate negative aspect to this dynamic. If the U.S. launches a preemptive strike on North Korea, I think stocks will fall about 10%. I also give that a 10% chance of occurring. With this new chance creeping into the market, stocks sold off.

Arguably, stocks should have sold off when Trump made that statement. However, I think they didn’t because it’s tough to figure out what the statement means.

This isn’t like how when a company reports earnings we know the direction the stock should go in based on the numbers. A political statement can have many consequences which are tough to analyze. With this type of situation, there will be knee jerk reactions as new information is reported.

If I was a long-term investor, I wouldn’t react to any of these issues.

If I was a money manager who needs to meet certain benchmarks every quarter, I’d sell some stocks here or buy defense stocks as a hedge because this is tough to gauge.
Let’s get into the specifics of the political options available. Keep in mind, the market wants certainty and peace. The latest developments increase uncertainty.

The issue at hand is that North Korea is threatening America and building up its nuclear capability. The U.S. doesn’t want North Korea to build up its capability because of those threats. North Korea says it won’t stop working on its nuclear technology, but it is open to peace.

Because North Korea hasn’t been complying with international orders to stop the program, there have been sanctions levied on the nation. The United Nations has recently levied $1 billion in new sanctions, one-third of the country's annual foreign revenue. North Korea exports coal, lead, iron, seafood, and has joint ventures with international firms.

Secretary of State Rex Tillerson had tried to get Thailand to enact tougher sanctions on North Korea. The elephant in the room is China because it is North Korea’s biggest trading partner and supplies food and energy. China added new sanctions again North Korea in July.

The issue the U.S. has is whether those sanctions are strong enough. America can threaten China to make the sanctions worse, but that threatens the U.S. relationship with China, the largest economy in the world. One of the biggest risks in this situation is U.S. sanctions on China as that would hurt trade just after Trump opened its markets to American firms earlier this year.

Besides fining China, as I mentioned earlier, the U.S. can launch a preemptive military strike on North Korea. The U.S. could attack North Korea’s nuclear weapons. It can also shoot down the next ballistic missile test or attack the launchers and testing facility. The second and third options are certainly smaller than the first, but they are all acts of aggression.

ooking at this from a game theory perspective, the U.S. wants to be as aggressive as it can stop the nuclear program without doing something that would be interpreted as a preemptive attack. A preemptive attack inspires a real counterattack.

From the stock market’s perspective, the less action both sides take, the better.

Looking at this from a more historical perspective, the stock market has been lucky with the peace in the world.

As you can see in the chart below, the percentage of Great Powers fighting in a war is now 0%. This peace makes stock multiples grow and improves earnings because multinationals can expand to any country they want.

Trading with nations allows for specialization which improves productivity and the standard of living for everyone. All these great aspects have the potential to stop working in corporations’ favor if there is an escalation of military actions between the U.S. and North Korea or an escalation of economic sanctions between the U.S. and China.

chart

In a past article, I mentioned that great earnings were preventing a correction caused by this geopolitical issue. Lately, individual firms have been falling off as Disney is down about 8% from its recent high because of an earnings miss.

Alphabet (GOOGL) stock is down about 7.5% from its recent high after its earnings report missed some whisper numbers.

The biggest one is Amazon (AMZN) which is down about 9% after its terrible earnings report which I highlighted a couple weeks ago. The stock market can rally without these firms, but it’s difficult when you combine their weakness with the recent geopolitical issues. When the leaders get taken out, new leaders need to spring up. That’s not going to happen with North Korea threatening the U.S.

Conclusion

The market is rightfully concerned with the geopolitical situation.

Any act of aggression could send the market down 10%. These are still low probability events, but the chances of them occurring have improved from nil to about 10%.

The sharp selloff in Amazon, Walt Disney Co. (DIS), and Alphabet doesn’t help the market. I said after Amazon’s quarter was released that it was a terrible result. The next possible catalyst for Amazon is the Christmas buying season in the fall. I don’t see the stock making new highs anytime soon.

Apple (AAPL) needs to have a successful iPhone launch to make up for the weakness in Amazon and Alphabet. 

 Subscribe to TheoTrade here...

Related Articles on STRATEGIES