The indices used for each asset class are as follows: the S&P 500 Index for large-Cap stocks; CRSP Deciles 6-10 for small-cap stocks; long-term US government bonds for long-term bonds; five-year US Treasury notes for five-year notes; long-term US corporate bonds for long-term credit; one-month Treasury bills for cash; and the Consumer Price Index for inflation. All index returns are total returns for that index. Returns for a war-time period are calculated as the returns of the index four months before the war and during the entire war itself. Returns for “All Wars” are the annualized geometric return of the index over all “war-time periods.” Risk is the annualized standard deviation of the index over the given period. Past performance is not indicative of future results. CFA Institute

The full period of study, 1926 through July 2013 is shaded in blue and provides a “control” group for comparison. Periods of war are highlighted in red. All of the individual wars we considered are listed below. Interestingly, both large-cap and small-cap stocks outperformed with less volatility during war times. The Vietnam War was the one exception, where stock returns were worse than the full period average. Even then, though, the returns were positive and above those of bonds and cash.

It is interesting to note that stock market volatility was lower during periods of war. Intuitively, one would expect the uncertainty of the geopolitical environment to spill over into the stock market. However, that has not been the case, except during the Gulf War when volatility was roughly in line with the historical average.

Capital market returns during the Gulf War were different from other wars. This war was very short, spanning less than a full year. This period also coincided with an oil price spike that helped push the economy into a brief recession. The idea of recession during war time was fairly new, and reflected the changing US economy. During previous wars, the economy was more exposed to capital goods and natural resources, which experienced greater demand to feed the war. However, by the 1990s, the economy had shifted away from heavy industry and toward the current “knowledge-based” economy. Thus, military demand had less of an impact, for better or worse, on economic growth.

Bonds generally underperformed their historical average during periods of war. This is likely, at least in part, because inflation has been higher during war times. Bond returns have historically been negatively correlated with inflation. Another explanation is that governments borrow more during wars, thus driving bond yields up and bond prices down. With the higher inflation and increased government borrowing associated with war time, investors seeking safety may want to think twice before shifting assets from stocks to bonds.

There are many economic and fundamental factors that impact security prices. Occasionally, a single event is powerful enough to dominate these other factors to singly influence capital market returns. However, historically speaking, this has not been the case with wars.

“None of this means that what happens in Northeast Asia is irrelevant. The threat of conflict there is real, and it is hard to imagine even in the current buy-the-dip market that outright military confrontation would be very good for stocks and corporate bonds that already are widely perceived to be richly priced,” Jakab concluded. “For now, the current dispute — despite its unusually strident tone from the U.S. side — remains one of words. . . . Something, some day, will end the current bull market, but mere words from North Korea probably won’t suffice.”

Economic growth, earnings, valuation, interest rates, inflation, and a host of other factors will ultimately decide the future direction of the stock and bond markets. While a knee-jerk decline is possible if war breaks out between the United States and North Korea, history suggests that any market decline should be short-lived.