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The only strategic market move to make next time North Korea conducts a missile test

  • North Korea's leader Kim Jong Un has overseen more missile tests during his reign than his father and grandfather combined.
  • Investors have increasing exposure to markets, such as South Korea, that are in the line of fire. Broad emerging markets ETFs have as much as 15 percent invested in South Korean stocks.
  • The stock market still views the threat of nuclear war as a low-probability event.

From July to mid-September, North Korea launched five missile tests, including two intercontinental ballistic missiles. More recently, the North Korean threat has taken a backseat to hurricanes and tax reform as stock market triggers, and major indexes are touching new record highs.

But "Little Rocket Man" will be back, as will headlines attributing short-term volatility in the market to a potential geopolitical crisis. Ahead of planned joint naval exercises between the United States and South Korea next week, North Korea threatened on Friday to launch ballistic missiles near the U.S. territory of Guam.

During Kim Jong Un's six-year reign, he has tested more missiles than his father and grandfather combined, including 15 tests in 2017. Based on history, there's one piece of advice that may come in handy for investors (and the current president) when Kim Jong Un celebrates his next nuclear success: Don't overreact. In fact, for investors, don't do anything.

Consider the country stock market arguably facing the gravest existential threat from a nuclear crisis: South Korea. There is reason not to be complacent. U.S.-based investors may have more exposure to South Korea than they realize.

Financial advisors and retail investors have been piling into overseas stocks, primarily through exchange-traded funds based on the MSCI and FTSE developed (EAFE) and emerging markets (EM) indices. Those indexes have significant exposure to South Korea. MSCI defines South Korea as an emerging market, and its emerging markets index has between 14 percent to 15 percent exposure to South Korea. The iShares Core MSCI Emerging Markets ETF (IEMG) has taken in $13.5 billion from investors. FTSE defines South Korea as a developed market, and its EAFE index has between 4 percent to 5 percent exposure to South Korean stocks. The Vanguard FTSE Developed Markets ETF (VWO) has taken in more than $14 billion from investors this year.

But here is what the South Korean stock market returned between the July to mid-September periods, when missiles were flying: 1.37 percent. Year-to-date, the South Korean stock market is up roughly 30 percent.

History of missile tests and the markets, 2003–present

There's a much longer history of North Korean missile tests than just this summer provided. Using Kensho, which provides CNBC with historical context for market-moving events, we looked at the reaction of major world assets after every missile test from 2003 to the present, 80 missile tests in all. The results: more muted than investors might expect.

But even Warren Buffett is worried

Without overreacting, concern about North Korea is rational for any investor. Just ask Warren Buffett. Last week the world's second-richest man said, "We have increased the ability of perhaps even an individual, perhaps a group, perhaps a nation ... to kill millions, millions, millions of people in a single stroke." Buffett added, "We got a fellow in North Korea [with a] very poor country, spending a way disproportionate amount of its GDP working on missiles that can hit California. That's crazy," he said. "Wish I had a solution for it, but I don't."

It's the "lack of solution" part that should bring investors backs to their senses, because especially in a markets' sense, there isn't anything investors can do about weapons of mass destruction. Do you really want to try and master game theory as an investor? The Wells Fargo Investment Institute has done some of that work for investors already, anyway.

"When you start assessing what the different outcomes might be and assign probability to each one, we still believe its biggest ally and biggest adversary, China and the United States, will together partner in order to put enough diplomatic pressure on North Korea to bring them back to table," said Sameer Samana, global quantitative strategist at the Wells Fargo Investment Institute, which recently sent some of its team on an Asia tour and trip to South Korea.

Other Asian investing specialists agree. Michael Oh, portfolio manager at Matthews Asia — the largest Asia-only investment manager based in the United States, with more than $31 billion in assets under management — wrote to the firm's clients at the height of summer tensions: "A positive outcome out of this complicated situation is that this may force China, Russia, South Korea, North Korea and the U.S. to finally engage in some kind of multilateral dialogue."

"There's almost always something on the front page that has implications for investor portfolios. Either you are avoiding all the major large developed markets and trying to find idiosyncratic exposure, or just embrace it as an investor." -Sameer Samana, Wells Fargo Investment Institute

Samana explained the Wells Fargo group's "intuitive analytical game theory framework" this way:

What do all the actors really want? When we consider the possibility of conflict, how badly do the parties — the United States, China, North Korea and South Korea — want to refight the Korean War? What might happen in that conflict?

"When we try to work through the questions, almost nobody wants it to happen. Could have major casualties in South Korea. Major casualties in North Korea. China drawn in and a possible loss of a critical ally on the border. Nobody wins," Samana said. "So we come back with a low probability."

Recent comments from CIA officials indicate that the agency believes the North Korean leader is a "rational actor" motivated by goals that will ensure regime survival. White House Chief of Staff General John Kelly told reporters this week that the North Korea threat is currently "manageable."

More from Global Investing Hot Spots:

Defense stocks soar on the spectre of war with North Korea
The biggest stock market trade of the year may be at a tipping point

But there's one big caveat that fits the current period: "History shows when things spiral out of control it's when we have rhetoric amping up and military exercises and missile tests and a flurry of activity," Samana said. "It's always possible to have an accident, a miscommunication."

Republican Sen. Bob Corker said in an Oct. 8 interview with the New York Times that all Americans should be worried Trump's rashness could lead the country into World War III. Defense Secretary Jim Mattis said on Oct. 9 that the U.S. Army should be ready with North Korea military options that "our president can employ, if needed." Speaking at an Army convention in Washington, Mattis said diplomatic efforts and sanctions continue "to try to turn North Korea off this path."

A North Korean official said this week that Trump has lit "the wick of war," and the final score will be settled "with a hail of fire, not words."

Samana said even taking into account "unintentional paths to conflict," it is a low-probability event.

"This isn't the first time tensions on the Korean Peninsula have been raised, only for them to be reduced again over a period of time," Oh reminded Matthews Asia clients. "Our basic assumption, given the seriousness of any conflict, is that there will not be a full-scale war breaking out on the Korean Peninsula."

Oh also noted that while "there has been some reaction in the markets, it has been more muted than headlines would suggest."

North Korea is "still simmering below surface," Samana said, but once you start investing in a diversified global portfolio, there will always be hot spots — that includes the United States.

"Our client base has a rotating list of things they are concerned about. Early in the year it was U.S. politics, then French elections, then North Korea. There's almost always something on the front page that has implications for investor portfolios," Samana said. "Either you are avoiding all the major large developed markets and trying to find idiosyncratic exposure, or just embrace it as an investor and stick to a plan."

The Wells Fargo official admitted that he has been surprised that we haven't seen bigger selloffs in markets closest to North Korea. China has done well. South Korea has done well. And emerging markets more broadly have been some of best-performers this year. "It has been a little surprising we have not seen a rotation away from some of markets closest," he said.

But what looks like "lots of complacency," in Samana's words, isn't as concerning when investors consider what they can and can't control.

Global bankers are still pumping money into the financial system, and pullbacks have been so short and shallow, investors have been rewarded for ignoring some of these risks. And with North Korea, "you struggle as a person to quantify this," Samana, the quantitative analyst, said. "It's not easy. It involves a small group of human beings, and human nature is notoriously difficult to quantify."

So that leaves investors with the metrics they can quantify: in addition to the central banking liquidity, global economic growth, increasing corporate profits and valuation. "And that's what has been going on," Samana said.

Ameriprise chief market strategist David Joy said it's these quantifiable factors that will continue to dominate actual market action: "Economic conditions are conducive to higher equity prices, and markets will continue to focus on this until compelled to do otherwise."

(Disclosure: NBC Universal, CNBC's parent company, is a minority investor in Kensho.)

WATCH: Here's what a land war with North Korea could look like

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