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Five Ways Investors Can Play The Turmoil in Middle East

Monday, 31 Jan 2011 | 1:32 PM ET

Financial markets may have taken a pause Monday after the violent swings of Friday, but it was only to let investors position themselves for a Middle East crisis that's unlikely to go away soon.

Traders work on the floor of the New York Stock Exchange.
AP
Traders work on the floor of the New York Stock Exchange.

Uprisings in Egypt and elsewhere in the region have raised concerns over instabilitythat could clog shipping lanes like the Suez Canal and make the climate highly volatile.

As such, most market pros were advising that safety would be the watchword going forward, though that doesn't mean there won't be ways to protect portfolios against the spillover effects from the unrest.

Much of the advice centered on gold, oil and currency, though the effects in the equity market are likely to be felt as well.

"Events in Egypt are unfolding quickly and further political change looks inevitable," Said Hirsh, Middle East economist at Capital Economics in London, wrote in a note to clients. "An orderly transition is still possible and would ensure that the disruption to markets in the region, and the rest of the world, is short-lived. Nonetheless, the risks of a more chaotic outcome remain high."

Here's a rundown of market sentiment in the wake of a chaotic weekend in Egypt:

1. Correction in Stocks

One of the more popular themes is that the turmoil could feed into a long-standing sentiment that the stock market is long-overdue for a correctionafter rising 22 percent off its August 2010 lows.

That talk has only intensified in light of the recent events and has some strategists gauging a pullback of 10 percent or more. Friday's selloff pushed US stocks down less than two percent, and the market is higher on Monday.

"A boxer is rarely knocked out by the punch he expects. It's the unexpected one that does him in," Sam Stovall, chief equity strategist at Standard & Poor's, wrote. "[T]he market has been trading on borrowed time, in our opinion, and was overdue for a digestion of gains. We believe a 5%-10% decline would be healthy, as it would reset overly optimistic investor sentiment and bring full-year price appreciation expectations back in line with our 9% price appreciation forecast."

David Rosenberg, economist and strategist at Gluskin Sheff in Toronto, sees the market as "ripe for a correction" after putting together nine straight weeks of gains. More than 80 percent of S&P 500 stocks are trading above their 200-day moving averages, a trend that preceded a 14 percent drop in the market last April.

2. Buying Volatility and Safety

As such, Rosenberg said investors need to be prepared both for a correction in stocks as well as the driving up of safety assets as the Egypt crisis unwinds.

"What is key for the markets is not just a renewed contraction in investor risk appetite and hence P/E multiple compression as we saw periodically last year, but also what happens to the price of oil in terms of any real dampening effects over the outlook for the economy and earnings," he wrote in his daily newsletter.

Specific recommendations include gold, oil, Swiss francs, short-maturity bonds particularly in Canada, Treasury Inflation Protected Securities, and options on the CBOE Volatility Index , often referred to as the market's fear gauge.

3. Looking for 'Hard' Assets

The gold and oil theme was a popular one in the investment community, though price moves were choppy Monday. Oil rose more than two percent mid-day, while gold was off marginally.

Middle East Turmoil
Middle East Turmoil

Still, the idea pervaded of holding onto inflation protection and trending away from things that could be negatively impacted by geopolitical disruptions.

"Strength in the gold market, in light of the situation in Egypt et al, and in light of the fact that gold had fallen right to its 150-day moving average...is simply reasonable," hedge fund manager Dennis Gartman wrote in The Gartman Letter. "Capital is frightened, and when capital is frightened it moves to gold."

In addition to the metal, Gartman recommended bonds and currencies for countries "the least involved and the farthest removed geographically from the situation," including the US, Canada, Australia and New Zealand. Also, he recommends "commodities that are intrinsic" such as the grains, natural gas, crude oil and copper.

"All else is suspect; all else shall devalue until the confusion of the situation wanes," he said.

4. Raising Cash

Selling pressure in the US stock market is weakMonday, volume is anemic but market breadth is strong after Friday's big selloff.

But weakness that could follow from emerging markets—looked by some to lead the global growth story this year—has generated sentiment for simply raising cash and getting some dry powder should the market pull back and present future buying opportunities.

Egypt: Excuse for Selloff?
Discussing whether unrest in Egypt was just an excuse to sell the markets, with the Strategy Session team.

"Quite apart from the developments in Egypt, emerging market stocks have been underperforming in recent months due to relatively high valuations and widespread monetary policy tightening in response to inflationary pressures," noted Bill Wetherell, chief economist at Cumberland Advisors. "For these reasons, we had already reduced emerging market positions in our international and global multi-asset class portfolios. The latest developments are leading us to raise cash."

Wetherell noted that the firm is pulling back even though it doesn't' own exchange-traded funds in any of the Middle Eastern markets except Israel.

5. Hedging Egypt Exposure

Those involved in the Middle Eastern markets, be it with equities or fixed income, find themselves in a quandary over how to reduce their exposure to blowups.

Credit Suisse strategists advised their clients that Saudi Arabian credit default swaps were the most sensitive to exposure to events in Egypt, and recommended looking at CDS in Bahrain as well. Investors also could look at shorting the Israeli shekel and using long oil funds.

On the equities side, Credit Suisse recommended telecom over real estate and said major land developer TMG and Commercial International Bank would be most affected by the crisis. On the upside, it said Orascom Construction Industries and EFG Hermes "stand out."

Indeed, Pimco co-CEO Mohamed-El-Erian, in an interview with CNBC earlier in the day, said "indiscriminate selling" would pose opportunities ahead.

"As investors, one has to look both at the defense and the offense," he said. "There are both opportunities and risks here."

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