In the Grip of Fear

Many commentators have noted that the war in Iraq set new standards in battlefield reporting. For the first time ever, television viewers at home are able to watch battles unfold live, in real time. Reporters “embedded” with coalition military units have transmitted mesmerizing images of war as it is actually being experienced on the ground.

This has had two notable consequences: (1) It has distracted millions of Americans from their normal habits, including shopping. People who are watching MSNBC or CNN 17 hours a day don’t have time to go to the mall. (2) Markets have displaced retired generals and military historians as the principal commentators on the war’s progress.

The stock market was so keen to get the war behind us that it staged a tremendous relief rally immediately after the fighting commenced. At the close on Friday of the first week of the war, the market was “priced for perfection” on the battlefield. When the following weekend brought evidence that progress towards Baghdad might be impeded by wrong turns, snipers, suicide bombers and sandstorms, the market immediately discounted the new images from the battlefield. Stocks sold off. The dollar plunged. So it has unfolded. Day after day, Secretary of Defense Donald Rumsfeld’s IQ rises and falls with the S&P 500 Index, which in turn reflects battlefield images transmitted from Iraq.

Wartime Markets: Hitched to a Battlefield Barometer

What conclusions can be drawn? The decimation of some Republican Guard units and the collapse and surrender of others underline the fact that even Iraq’s best soldiers are no match for coalition forces in a set piece battle. [At this point the military strategy in the region with respect to countries like Syria is essentially unpredictable]. But, like most of the Middle East, Iraq is full of fanatics who are prone to extravagant behavior. There could be continued suicide attacks. With strong evidence that the broad stock market, as well as bond and currency markets, are hitched to a battlefield barometer, you can expect extraordinary volatility for some time to come.

A feature of the market volatility to be expected is the prospect of at least a temporary upside breakout of the current trading range. As I write, the stock market has broken beyond the S&P 500 880 resistance level. This has held a long time, so the overhead resistance was strong. But it gave way with growing evidence from Baghdad of the impending collapse of the Saddam Hussein regime. I rather expect the whole show to be over soon, probably by the end of April. The market should then rally. If so, I expect the market’s gains to be contained by the S&P 500 965 resistance level. As master technician, Philip Erlanger observes, “It is resistance on a major scale, as it represents the ‘neckline’ of the head & shoulders top pattern that spans 5 years.” This suggests that the victory rally will be short-lived, followed by a retreat for all the indexes.

In fact, a close look at the market action of last week may provide a key to future developments. The first two Mondays of the war were down days, as weekend news discouraged bulls. But the weekend of April 4-6 brought TV images of American tanks rolling through Baghdad. By Monday morning, the bulls were in full control. The markets sprang open to the upside. With the day’s highs established early, the market then began to give back its gains.

Rates on benchmark 10-year notes rose to their highest mark in two weeks, indicating that investors were discounting more rapid growth of the economy following the end of the war. On the other hand, short-term yields lagged, reflecting the contradictory fact that investors on the short end of the curve expect yet another Fed interest rate cut to stimulate economic growth. The yield gap between 2- and 10-year notes got as wide as 240 basis points [2.4%] on Monday. That was the biggest yield gap since 1992, as longer-term interest rates rose while short-term rates held on the expectation of the Federal Reserve rate cutting kept short rates low. A Fed rate cut, which could come at any time, would presumably fuel the victory rally we have been expecting.

Wartime Markets: What Comes Next

Note that movements in interest rates, currencies and the stock market reflect the fact that, as CBS MarketWatch said, “Many economists consider the conflict the biggest obstacle to a U.S. economic recovery.” Obviously, the war is winding down. Forming an expectation of what comes next calls for delicate judgment.

There are two major camps of thought about what happens in the wake of a convincing victory in Iraq. Bulls hope that a quick end to the war will lift animal spirits and unleash consumer and business spending that has been curtailed by uncertainty. Bears expect spending to fall short of igniting sustainable growth. The market has been giving the benefit of the doubt to the bulls, as the robust gains in the first week of April attests.

Now we are poised to learn the answer to the most important question that you have to face this year as an investor. How much of an expectation of better times ahead should be priced into the market?

This is partly a question of current specifics. It is partly a question of attitude. As far as the current circumstances are concerned, I have been of the view that the war would clear away some obstacles to growth. In particular, I expect the end of the fighting to lead to a period of steadily declining oil prices. As we have detailed in the past, lower oil prices stimulate consumer spending. They are the equivalent of a tax cut worth hundreds of billions of dollars over the coming years.

Also, the end of the war gives hope for reconciliation between the United States and its trading partners, most prominently Germany and France. This could be crucial to the continued expansion of world markets, from which the United States stands to gain more than any other economy. By halting the deterioration of relations, the end of the war may bring a generally unpleasant phase of international relations and domestic preoccupation with terrorism to a close.

Wartime Markets: Us-Canada Trade

This could be particularly important in an area to which most Americans have given less thought – North American trade. The end of the war may bring an occasion for the United States to relent in its drive to constipate cross- border travel between the United States and Canada. Trade between the two countries is more active, at a higher dollar volume, than between any other nations. A million dollars’ worth of trade takes place between the United States and Canada each minute.

Much of this trade is in components for just-in-time production. As the North American economy has become more integrated, it is also more crucial for U.S. prosperity to keep cross-border flows fluent. But beginning on Sept. 12, 2001, the border along the 49th parallel has become ever less user-friendly. In the immediate aftermath of the terrorist attacks, border traffic jams began to stretch as long as 12 miles, with crossing delays lasting the better part of a day.

As if this were not bad enough, the U.S. government has moved to institutionalize these delays by requiring more paperwork, especially in creating a registry to record who is leaving the United States to go to Canada. “I am terribly worried. There is definitely some damage that has been done,” says Thomas D’Aquino, head of the Canadian Council of Chief Executives, a group of more than 100 of Canada’s leading companies. D’Aquino laments strains in U.S.-Canadian relations. “A lot of people have said they are worried and are concerned about what may lay down the road,” he said. “There are hundreds of millions of micro transactions that go across the border each day.” The fewer obstacles imposed to block these transactions, the more prosperous Americans will be.

Perhaps the end of the war will lead to some relaxation in the manic drive to close the U.S. economy in the name of security. Of course, even as I write, I am aware that this may be wishful thinking on my part.

At this point, there is no conclusive reason to hope that even a violent catharsis could free Americans from our fixation on terrorism and the grip of fear that surrounds it.


James Davidson,
for The Daily Reckoning
April 15, 2003


Everybody expects the end of the war to bring the beginnings of a boom. My old friend, Mark Hulbert, reports that he has never seen such a huge shift of sentiment as happened between March 10 and April 10…when his index of 50 leading market timers went from an average equity exposure of minus 19% – indicating extreme bearishness – to plus 46%, an indication of remarkable bullishness.

But last month’s bearishness didn’t pay off. Neither might this month’s bullishness.

Paul Samuelson writing in Newsweek: “Wars usually bring surprises and disappointments in their wake. A harsh depression – one of the nation’s worst, says historian John McCusker of Trinity University in San Antonio, Texas – followed the Revolution. Trade with Britain had shriveled; hard money (meaning silver and gold coin) was scarce. The government, operating under the Articles of Confederation, couldn’t cure the country’s commercial problems. The Constitutional Convention was one consequence. “The war left the country in a condition that people couldn’t deal with and hadn’t planned for,” says McCusker. “This was no fluke; wars often do that. Gradual deflation followed the Civil War; World War I fostered inflation, which led to a deep recession (1920-21); Vietnam helped cause rising inflation. Only after World War II has the economy escaped the curse.”

So far, the war has been a boon – but not for America.

“Global investors appear to like U.S. assets less and less,” says a headline on CNN/ Foreign stock markets have risen more than Wall Street, the article explains. And major foreign debt markets have become more attractive. An investor can get a 4.2% yield on German 10- year notes…4.5% on the U.K. variety…and only 3.9% on the American brand.

While American consumers worry about having too few dollars, foreign investors worry about having too many. If anything were to get a boost from the quick and easy victory of American forces in Iraq, it should have been the dollar. Some people even believed the war was nothing more than an attempt to preserve the value of the imperial currency. But, the buck did something ominous yesterday. Gold futures dropped $3.60 to $324.90. The dollar should have gone up. Instead, it fell against the euro.

Every little ebb of the greenback increases foreign investors’ fear of the dollar, while also increasing the return from overseas investments. Another 10%-20% decline in the dollar – such as happened in the last 12 months – would give investors in euro bonds a 25%-plus return. Who would want to hold dollar-based assets with the dollar so vulnerable?

Here’s Eric Fry with more news and clever commentary from Wall Street:


Eric Fry in New York…

– Question: If a bomb falls on Baghdad and the stock market price level does not change, did the bomb make any sound?…Judging from the resurgent stock market, it almost seems as if the little skirmish over there in the Middle East never actually happened. After yesterday’s gains, the stock market sits almost exactly where it was on March 19, the date that the initial salvo of cruise missiles landed on Baghdad. Yesterday, the Dow Jones Industrial Average nosed into positive territory for the year by gaining 147 points to 8,351. The Nasdaq jumped 1.9%, bringing its advance for 2003 to 2.6%.

– It would seem that the Iraqi conflict was a non-event for the stock market. However, an alternate interpretation is that the stock market would be much lower, were it not for the pleasant diversion of one-sided U.S. military success in Iraq. That’s because the news on the home front is just as bad as it was four weeks ago, when the bombs first started falling, and stocks are just as pricey as they were four weeks ago, too.

– The economy and the stock market both continue to muddle along. But at least the stock market has been muddling mostly to the upside. The same cannot be said of the economy. Stockpiles at U.S. businesses jumped a larger- than-expected 0.6 percent in February to the highest level since September 2001. Meanwhile, February’s business sales fell the most in over a year, down 1%.

– Curiously, despite these downbeat numbers from the Commerce Department, the trading action of the bond market seems to reflect an economy on the mend. The benchmark 10- year Treasury note fell 10/32, pushing its yield to 4.02% from 3.97% Friday. Is the bond market signaling renewed economic vitality? Or might the bond market’s recent weakness be signaling a brand new bull market…in government!

– “In New York this reluctant spring, the government is more visible than the forsythia,” writes Jim Grant. “At the corner of Broad and Wall, police officers pack machine guns. Just across the East River, at the Clark Street subway station in Brooklyn, cops sometimes outnumber straphangers…”

– “Is Big Government Back?” asked Tom Gallagher in a talk he delivered on March 24 before the National Association of Business Economics. “For the better part of the last 20 years,” writes Gallagher, Washington analyst for the ISI Group, “the prevailing approach to solving problems was to reduce the role of government. Now I think we are on a trend in which the predominant approach to solving problems will involve an expanded role for government…”

– PIMCO’s Paul McCulley seconds the notion that a bull market in government is underway. As McCulley points out in a recent interview with Welling@Weeden, “There are a number of things that capitalism really can’t do very well. The top two on the list, I think, are dealing with deflation risk and providing national security. The upshot is that we’ve had a profound one-two punch for a bull market in government…

– “A bull market in capitalism was good for a tripling of the P/E multiple during the 1980s and ’90s – the tripling of the P/E ratio was what the whole bull market in stocks was about. It certainly wasn’t about real earnings growth, merely a revaluation of earnings…[But] if you start with the premise that capitalism is in retreat and that we have started a new bull market in government in which markets don’t necessarily dominate, but sovereign nations enforce their wills, that doesn’t at first blush tell you that P/E multiples on stocks are likely to go up. But it does tell you that the equity risk premium is too damn skinny….What it tells you is that the starting point valuation is a residual of the bull market in capitalism – and is not necessarily what you would ideally sketch out at the beginning point for a bull market in government.

– “The most pleasant thing that could happen,” McCulley winds up, “would be for stocks to meander around where they are for a long, long time.”


Bill Bonner, back in Rome…

*** We have been trying to find an appropriate historical precedent for Operation Iraqi Freedom. Britain’s Zulu wars or its war with Turkey for Greek Independence came to mind last week. Here in Rome, Trajan’s campaign against the Parthians comes to mind. He attacked from the side opposite to the approach American forces took. Beginning on the Mediterranean coast at Antioch, he marched East in the year 114. By 116 he was in Ctesiphon, now Baghdad, where he installed a puppet king. From there, he continued to the Persian Gulf and on to Baasra.

Trajan died the following year, having brought the Roman Empire to its very peak of expansion. After 8 centuries of a bull market in Roman power, under Trajan, the empire reached its bubble top. Even before Trajan’s death the following year, the Parthians revolted and, once again, lower Mesopotamia slipped out of Roman control.

*** Wandering among the ruins…gawking at the Coliseum…the baths…the temples…the immense columns of marble…we are as awe-struck as other tourists. ‘How did they get that up there,’ we wonder, craning our necks at a huge block of marble balanced on top of an enormous column. Where did they get the labor…the money…the energy…for all this monumental construction? (More on Friday…)

*** But we are beginning to like the idea of empire. Not that we think it is good or bad – for who are we to judge the currents of history? – but that it is such a spectacle. Where else might the lumpen mobs get free bread…and then watch mock naval battles…or Christian martyrs getting torn apart by lions…or gladiators fight to the death? And where else could the average citizen look out at such architectural splendor – Caracalla’s baths…Titus’ arch…Trajan’s column? Only emperors could build on such a scale…and only citizens of a great empire could enjoy such extravagance. And only because of such bubbles in world history can tourists today tromp over Rome’s ruins and feel as though they were learning something.

*** What your editor has learned is that the Italians make good wine. While he wallows in history, he studies the Michelin restaurant guide as though it were the Rosetta Stone and explores the local wines as though he were Champollion entering the Great Pyramid. What has he discovered? That a few hours on the Palatine hill is enough to give him a good appetite…and that a good Chianti Classico or Lambrusco or Barolo is a good as a Bordeaux.

*** We were walking along the Via del Corso and saw a familiar face. There, in a wedding dress shop, was a poster with a photograph of our own daughter, larger than life. Maria had done some modeling for wedding dresses a few months ago, she recalled, but had never seen the photos. But here they were…in a shop in Rome. Entering the store, Maria was treated like a celebrity…the owner got a photo of her in front of the poster…and told her to come back when she was ready to get married!