When Market’s Get Rattled: The Flight to Quality

What began as a localized uprising in the small North African country of Tunisia has spread throughout the Middle East. The Economist magazine notes that Egypt has long been a political bellwether for the Arab world. If that’s so, then Mubarak’s exit signals that other Arab regimes may be in jeopardy. Decades old dictatorships have now fallen in two countries now and a third fall seems imminent already as rebels appear to control the eastern part of Libya.

What does this political unrest mean for traders and investors? One thing for sure: it means more volatility. If the negative news from this region continues, it will drive equity prices down and oil prices up. We saw big jumps in volatility (stocks down, oil up) on 1/28 (Egypt’s significant news day), and on 2/22 (when the Libyan air force killed hundreds of protestors). We should probably be prepared for similar conditions, and we can also benefit from another phenomenon that occurs when volatility picks up.

Flight to Quality

Until the unrest stops spreading, we should expect a continued flight to asset quality. We saw that yesterday (2/22) as bonds and gold rallied. In the equities markets, there is also a shift to quality. In times of turmoil we see people leaving riskier sectors (like small caps) and heading into large cap stocks. The chart below shows the ratio of the S&P 500 (large caps) versus the Russell 2000 (small caps).

During the biggest scares of the real estate and credit crisis during the fall of 2008 and spring of 2009, the S&P 500 was at its highest valuation versus the Russell 2000. Recently, however, the markets have been more complacent and moving up so people value the Russell more highly. Investors have felt safe enough to chase bigger returns. You can see that trend in ratio indicator (the blue line) in late 2010. Now, the ratio indicates that S&P valuations just started to pick up a bit.

The US equities markets have been stretched to the upside for some time. With the current political turmoil, the markets may finally find a reason to relieve its overbought condition.

Canons and Trumpets

This is probably a good time to remember Lord Rothschild’s famous epigram to “’Buy to the sound of cannons and sell to the sound of trumpets.” In other words, buy at the start of a conflict (when things look bleakest) and sell when everyone else celebrates the end of it. In our case, remember that negative geopolitical news will drive equity prices down and oil prices up, but they will likely rebound after the impact of the news wears off.

I’d love to hear your thoughts and feedback on this article or about trading and investing in general at drbarton “at” iitm.com. Until next week…

Great Trading,
D. R.