Will the Stock Market Crash because of the Iran-Israel Conflict?

On Saturday, 13 April, Iran attacked Israel.

The much-anticipated attack as a response to the strike on Iran's consulate building in Damascus, Syria, is being seen as a huge escalation in the ongoing tensions in the middle east.

It's no wonder that financial markets crashed today. Even on Friday, the US market had taken a beating.

Will this event be the trigger for a correction in the Indian stock market...the one that everyone keeps talking about, but which never happens?

How Geopolitics Impacts the Indian Stock Market

Geopolitics has always played a role in the movement of asset prices and the direction of financial markets all over the world. This has been true for the short term as well as the long term.

No two geopolitical events are the same and they have varying impacts on financial assets like stocks.

For example, the 7 October 2023 attack on Israel by Hamas had only a short-term impact on stock prices. Despite the fact that a was broke out, markets rallied. This was because the thinking at the time was that the war would be contained to Israel and Hamas.

We wrote about that in detail here.

However, the recent attack on Israel is of a vastly different scale. As of this writing, Israel hasn't decided how it will respond or when. And this has caused uncertainty in financial markets.

There are very few certainties in the markets but if there is one thing that every market participant agrees on it's this: Markets hate uncertainty. If there is to be a serious correction the Indian stock market, uncertainty will play a big role in it.

This is because the Indian stock market is being drive by a massive surge in liquidity from domestic investors. This flow of money is so strong that it prevents the market from falling even when foreign investors are selling. This is why corrections have been few, infrequent, short, and shallow.

This is a departure from the past when FIIs dominated the Indian market. Now the only thing that can cause a serious correction is the slowdown in the flow of money into the market from Indians themselves. This will only happen if Indians feel unsure about the returns from the stock market.

This is why geopolitical events by themselves can't cause a serious correction. But the uncertainty that they cause, especially over the long term, can play a role in it.

What About a Crash in the Long Term?

In the long term, there will certainly be a correction in the market. That is inevitable. The only questions are when it will happen, how long it will last, and how deep it will be.

Of course, no one can provide clear answers to this. But we at Equitymaster have tried to provide readers with some context about such market crashes for the purpose of better understanding them.

Armed with this information, you can make better decisions about your portfolio.

So, what does Equitymaster think about the possibility of a market crash?

Well, as long as the overall market sentiment remains positive, then despite setbacks like the latest geopolitical shock, the overall trajectory of the Indian market remains up.

And if the FIIs re-join the party, we could see the Nifty easily soar past the 25,000 mark.

We at Equitymaster aren't concerned about specific Nifty levels as much as the valuations of the market and specific stocks.

The recent correction in midcaps and smallcaps has helped to bring down valuations, at least to some extent in these stocks. But the overall market's valuation still remains high.

This is important because the higher the market's valuation goes, the more vulnerable it becomes to a crash. We measure valuations of the overall market with the Nifty PE ratio which is currently at 23.1.

The Nifty PE acts as a good thumb rule to gauge how expensive stock prices are. The Nifty PE is close to the 25 level, a point where professional investors begin to feel uncomfortable.

According to us, the market would enter bubble territory only if the Nifty PE went above 25 and kept going up from there without any sign of a decline. The closer it gets to 30, the more dangerous the market would become for the bulls.

Right now, the bulls feel comfortable because of the strong economic growth, regular flows of funds coming into the market, rising earnings, positive sentiment, expectation of a favourable election result, and the possibility of more economic reforms if the government is re-elected.

This is why the bulls won't lose their confidence in the face of a big geopolitical event. They believe there is more upside to the Nifty.

The Other Side of the Argument

What we have stated above is a reassuring picture, but it would be incomplete without presenting the other side of the argument.

The bears say the market is already overvalued and vulnerable to a crash. In their opinion, rapid earnings growth cannot continue indefinitely. Once earnings growth slows down, the market will be on shaky ground.

Also, external shocks, like the one we have just seen, was being completely ignored. This is true.

The bears' argument basically boils down to one important point. If the market continues its rise, stock prices will rise faster than earnings. This will take the Nifty into bubble territory not in a few years, but in a few months.

In fact, this becomes even more likely if the bulls get what they want from the election results.

So, the bear argument is that the bulls themselves will be cause of the next crash. The actual trigger of the crash won't really matter in the bigger picture.

As market analysts with over 25 years of experience in the stock market, we at Equitymaster acknowledge the merit in this argument. What the bears are saying has happened before and can happen again.

But as things stand today, there's no need to dump your stocks...unless they're of a fundamentally poor quality or the main reason for investing in them has changed.

Otherwise, we believe the wait and watch approach which many investors are employing right now, seems fully justified.

In fact, if there is a correction, and this causes the prices of some fundamentally strong stocks to fall, there could a good buying opportunity for long-term investors.

Don't miss out on that.

Happy investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...