In awful weeks like this, investors, who usually worry only about the state of their portfolios, get very concerned about the state of the world. Every day they wake up, turn on their terminals, and ask: How screwed is mankind today? And if we're that much closer to World War III, how should I protect my investments?
There's no shortage of data and advice. At Intrade and other prediction markets, amateurs trade futures contracts on political events. Consulting firms like the Eurasia Group offer in-depth reports on geopolitics. Investors can sift through measures of sentiment like the Conference Board's Consumer Confidence survey or the Investors Intelligence survey of market advisers.
But for quantitative types, these are all deeply unsatisfying. They measure opinion and feeling as opposed to action in the markets, and the surveys don't measure real-time data.
Investors can gauge geopolitical risk by checking out the price of gold or oil or interest rates. The Volatility Index, also known as the fear gauge, is another popular measure of skittishness. But in isolation, these may not be accurate measures of the degree of international anxiety. Gold rises in time of war, but it also may rise when investors fret about inflation. Bonds move on geopolitics, but they also move on the utterances of Federal Reserve Chairman Ben Bernanke.
What's needed is a good aggregator of geopolitical risk. Economists rely on the Consumer Price Index, an aggregation of prices of many different goods and services, to tell them what's happening with inflation. Investors rely on the Standard & Poor's 500, an aggregation of 500 different stocks, to tell us what's going on in the broad market. So, what if you could come up with an index of different securities whose aggregated movements reflect geopolitical risk? What if someone could develop a single number that shows just how freaked out the world is at any given time of day? Behold Citigroup's Geo-Political Risk Index. (Full disclosure: One of the brains behind this operation is my brother Leon Gross.)
The number-crunchers at Citigroup looked at the behavior of certain assets—gold, interest rates, volatility of stocks, etc.—and how they behaved in the run-up to, and aftermath of, geopolitically significant events in the past decade. The goal was to weight them in such a way that, taken together, they would present a stable reading in comparatively calm times but would rise in times of crisis. They picked six well-known and somewhat interrelated components: the aforementioned volatility index, the price of crude oil, the implied volatility of crude oil (how much the market thinks the price of oil will rise or fall), the U.S. Dollar Index, which tracks the dollar's value against a basket of currencies, the two-year Treasury bond, and an index of gold stocks.
In times of relative calm, these components move in more or less random patterns and tend to cancel each other out. But when crises happen, they tend to move in tandem. Citigroup ran the figures back to 1995 and overlaid them on big macro anxiety-inducing events: the Asian debt crisis of 1997, the Long Term Capital Management debacle of 1998, the 2000 U.S. presidential election, etc. They found that the index generally hovered in a range around 120 but spiked when bad things happened. The biggest move, not surprisingly, came in the aftermath of the most shocking event in recent memory: 9/11.
The index jumped more than 20 percent, from 126 to 152, when the markets reopened on Sept. 17. It reached its highest reading ever on Sept. 24, 2001, when the Taliban called for jihad against the United States, but subsided as the invasion of Afghanistan went smoothly and fears of further attacks diminished.
In 2002 and 2003, the Geo-Political Risk Index climbed every time it seemed war with Iraq was more likely, reaching a peak of 154.52 on March 17, 2003, when President Bush said Saddam had 48 hours to leave Iraq.
The index started falling once the war began and quickly reverted to normal levels. Things were pretty placid on the index this spring, but it started rising in May when a broad-based sell-off in emerging markets started. And in the last few weeks, with the outbreak of fighting in the Middle East, it has spiked again. Today, the index stands at an elevated 129, down from a dangerous 134.5 last week.
So, what's the point of this index, other than to make the nervous among us even more nervous? There's no single exchange-listed security yet that allows a trader to buy and sell geopolitical risk as measured by Citigroup, although a trading desk could construct a customized one for sophisticated institutional investors. But in theory, options on such an index would allow big investors to hedge their portfolios against the prospect of global meltdowns, much the same way options on the S&P 500 allow investors to hedge against the prospect of a slowdown in the U.S. stock market. And investors who are optimistic about diplomacy could express that view by going short on the index.
The index would also seem to have some utility as a great contrary indicator for individual stock investors. As Nathan Rothschild is presumed to have said: "Buy to the sound of cannons, sell to the sound of trumpets." When everybody is scared and looking to dump stocks in favor of gold and bonds, it is usually a good time to buy. Looking back over the last 10 years, jumping into the market when the index was at a high level would have been a smart short-term trading move. So one might imagine that a nice round of nuclear brinksmanship with Iran would send the Geo-Political Risk Index soaring—and present a nice opportunity for opportunistic investors. But my brother Leon Gross adds a caveat: "That contrarian strategy only works to the extent that the U.S. and the developed world's economies will survive these shocks and not be crippled by them." In which case day traders might be too preoccupied with getting through Armageddon to trade light crude-oil futures.