Ahmadinejad - Reuters - 2.2012
Iranian President Mahmoud Ahmadinejad, left, and Gaza’s Hamas Prime Minister Ismail Haniyeh gesture at a rally. Photo by Reuters
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Israel's capital market has correlated almost entirely with those in the developing world since 2009, but the trend seems to be breaking down this year. Tel Aviv's leading indices are on the upswing, but they have started losing ground to the MSCI emerging markets (MXEF ) index. One explanation cites mounting discussion of a potential Israeli attack on Iran.

Several U.S. media outlets have been reporting hints that Israel intends to bomb Iran's nuclear facilities within the next few months. A Washington Post article said U.S. Secretary of Defense Leon Panetta believes there is a strong likelihood that Israel will strike Iran this spring. NBC charted the flight paths and described the missiles that might be used. Iran, for its part, warned that its response would be "painful," and would include bombing Israel in return and closing the Strait of Hormuz, a vital route for transporting oil.

U.S. President Barack Obama, referring to such a possibility, said he didn't think Israel has made a decision on the matter, the New York Times reported. But, the paper reports, Obama says he understands Israel's concerns. The president also said the administration doesn't see any evidence that Iran has any intention or ability to attack the United States. He said nothing, however, on Iran's intention or ability to strike Israel.

How would Israel's stock market react in the case of an escalation?

"Every war brings the market down for the first few days," says Yoram Gabai, chairman of Peilim Investment Portfolio Management. "What happens afterward depends entirely on whether the war's end is within sight. The market understands the violence is temporary and corrects itself quickly when the decision on a ceasefire is in Israel's hands, or when the U.S. attacks and the outcome is certain. If things are heading toward escalation or a lengthy conflict, the market will keep dropping."

Take the performance of the benchmark Tel Aviv-100 Index during major military conflagrations in recent decades. The capital market bounced back rapidly each time Israel or the United States initiated and was capable of ending the war. But whenever the conflict dragged on inconclusively, the capital market languished.

During the Second Lebanon War, for instance, investors quickly understood that the fighting wouldn't profoundly affect the economy, says Gabai. "After three or four days, Hezbollah already had asked (then-Prime Minister Ehud ) Olmert for a ceasefire," he explains. "The market knew this so the recovery began on the fourth day, even though fighting continued in the North."

An even better example of a military conflict not affecting the market was Operation Cast Lead in Gaza three years ago, when Israel maintained the initiative throughout, says Gabai. "The Palestinians didn't shoot at all, and Israel could have ended the operation at any point. The market fell only one day and then resumed climbing."

The first Lebanon war and the Al-Aqsa Intifada are the other side of the coin. "The first Lebanon war is the perfect example of going to war without knowing how to get out," says Gabai. "Israel demolished Lebanon's political system, creating anarchy, and couldn't withdraw. As a result the markets sunk, Israel's economy collapsed, and inflation took off."

The Al-Aqsa Intifada 10 years ago had a similar effect. "Both [then-Palestinian Authority chairman Yasser] Arafat and [then-Prime Minister Ehud] Barak thought at the time that if there wasn't an agreement there would definitely be an escalation," says Gabai. "The market understood that a lengthy conflict lay ahead, and this led to three or four years of drops on the stock market and negative economic growth in real terms. This was on top of the direct damage caused by the uprising."

'If Israel attacks alone, we'll be in trouble'

But the most fascinating example of the connection between a military conflict and the capital market was the Gulf War. The TA-100 dropped about 20% in the first seven trading days after Iraq invaded Kuwait in August 1990. The recovery began the day the Americans attacked Iraq in January 1991. "The moment victory was clear, the market began rising, even though missiles had just begun falling on Israel," says Gabai.

In the event of an attack on Iran, says Gabai, the market can be expected to fall for several days at first, but past experience shows that what happens afterward largely depends on who does the attacking.

"If it's the U.S. that attacks, it will obviously determine the war's fate relatively quickly," he says. "So even if the market falls it will recover fairly quickly - even if Israel is hit."

But if Israel decides to strike alone, that will be an entirely different story, says Gabai. "In this case we'd be in trouble. The Iranians could close the Strait of Hormuz and just fire long-range missiles at Israel."

Gabai assumes that if the U.S. doesn't start the war, it won't interfere later, either. This leads him to conclude that Israel can't attack Iran on its own. "Israel can't protect its population from a missile attack," he claims. "We saw this in the Gulf War. Without the ability to prevail and no mechanism to bring a ceasefire, the conflict could last for months. In this case the markets will obviously fall drastically."

In war, like investing, you need an exit strategy before starting out, concludes Gabai.