Iranian stand-off may not affect of equities

Serious Money: Oil price could surge again, but investors should use short-term weakness as a buying opportunity.

How should the rational investor take on board the situation in Iran? The determination by the Islamic republic to develop its nuclear capabilities represents obvious risks to global security and shows all the signs of being a problem that is likely to get a lot bigger before - or if - it is resolved.

There are all sorts of ways that the situation could play out, but the number one economic - as opposed to military - risk is that oil prices spike, perhaps to $100 (€81) a barrel or more. Iran, as the world's second largest oil producer, wields considerable clout and appears very willing to play a high-stakes game.

One approach would be to try to undertake a detailed strategic analysis of the situation. In the absence of the resources of the CIA or MI5, we might think such a task is beyond us. But we do know that the Iranians seem to hold more cards than the West: they have the oil.

UN sanctions might just have the effect of raising the oil price while playing to the mullah's desire to turn off supplies of ungodly western goods and services to Iran's relatively young population. Any sanctions would be likely to elicit a nationalistic response from the Iranian people, dashing the hopes of those who hope for a revolution from within.

The West has little military appetite or resources. Hence, we might conclude that it is inevitable that the Iranians will acquire the bomb. In which case, we then have to think about how Israel might respond to this. And few of the conclusions we would draw would be pretty ones.

But, as we already mentioned, this kind of analysis draws on publicly available information and, as such, is probably very limited. Our confidence in whatever conclusions we reach must be very low indeed.

But even if we think there is a low probability of a cataclysmic event, it must somehow be factored into our decision-making process. But in what way?

Most obviously, if we are concerned about oil prices spiking for a prolonged period, we should almost certainly avoid equities. That conclusion would be merely reinforced if we think that military confrontation is remotely probable.

But is the right response to cut our investments in stocks? Mathematically, if we have attached a small probability to a catastrophe, does that mean we make a small or large change to our equity allocation?

I'm not sure that there is a right answer to this question. Clearly, there is a non-negligible risk that something terrible might happen. Logically, this should make us very nervous about equities, and the recent sell-off in global markets has undoubtedly got something to do with these concerns.

But, all things considered, markets have been remarkably well behaved: arguably, recent weakness has had more to do with earnings reports from the US than the Iranian situation.

Taking a step back from the specifics of the stand-off with Iran, we might think about how similar situations have been treated by markets in the past. If equities are the ultimate discounting tool - always assimilating probable outcomes, good, bad or indifferent - how have they dealt with potential catastrophe in the past?

It is not obvious that markets got terribly excited during the Cold War: most of the time, the threat of nuclear armageddon seemed to be either ignored or regarded as negligible.

Indeed, when the nuclear arms race was at its height, equities at times did rather well. Ultimately, this proved to be a rational response, but only with the benefits of hindsight.

Historically, equities have not got a good track record of anticipating catastrophe. Perhaps the most widely cited example of this is the first World War: according to some accounts, stocks failed to respond very much, even after the war had actually started. The authorities were able to close down some markets before prices had fallen by very much.

History, therefore, teaches us very little. It has paid to be an optimist and not worry too much about geopolitics or potential global catastrophe, but that has been because things have generally turned out okay. Even world wars have produced relatively small blips on the charts of long-term stock market performance (one clear and unsurprising historical lesson is that, from an investment perspective, it pays to be on the side of the winners of wars).

Does any of this help us with regard to the dilemmas thrown up by the Iranian situation?

History suggests a relatively relaxed attitude. Indeed, any short-term weakness in markets should be used as a buying opportunity, particularly by those lucky enough to be able to take the long view. But for those whose horizons extend just over the next couple of quarters, it is hard to see much to be optimistic about.

As much as we can talk about the excellent prospects for economic growth and profits, if the oil price is headed for $100 on worries about Iran, equities, with the exception of oil companies perhaps, will not be a good investment.

For what it is worth, I think markets are, in fact, being quite rational in trying to look through all of this and to take a relatively sanguine attitude.

Equities, at the end of the day, are about investing in the future. If you are the sort of person that thinks about the future in rather bleak terms, then stock markets are not for you. Stocks didn't look too good a bet at the height of the Cuban missile crisis, but we know how that saga ended.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.