Perfidy Pays the Price

Contrary to many forecasts and the devout hopes of Howard Dean, Jacques Chirac and the Axis of Weasels, the war in Iraq is over. The good guys won.

The downside of lying was convincingly demonstrated by the Anglo-American rout of Saddam Hussein and his merry band of plunderers. Notwithstanding the stark evidence of success, however, broadcast around the world by “embedded” reporters, the anti-war core of the Democratic Party in the U.S. continues to oppose the war and criticize U.S. aims in cleaning up Iraq.

This is remarkable on several scores. It is one of the first times in history that political campaigns have been based upon opposition to a short, successful war. Would Eugene McCarthy have run against the war in Vietnam if the war had been won a year before the first primary?

The other issue is one of mendacity. It is an illustration of how facts can get lost in a fog of ideology. As an investor, you should not let the media bias confuse you about the impact of the war. It is far more positive than you would be led to believe.

Mendacity: The World’s Superpower

Firstly, the real-time demonstration of American military technology in walking over Iraq’s vaunted Republican Guard divisions has had a major impact in reinforcing perceptions of America as the world’s superpower. One of the more important impacts of this shift in recognition is likely to be felt in the Korean Peninsula, where the Chinese government is likely to join the U.S. in pressuring North Korea’s megalomaniacal dictator, Kim Jong Il, to de- commission his nuclear weapons program.

The new Chinese leadership are not as stupid or unrealistic as the Dixie Chicks and the reflexive anti-war contingent in the U.S.. Saddam may, or may not have had weapons of mass destruction. But there is no doubt North Korea does. North Korea cannot survive without Chinese backing. If the Chinese, awed by the latest demonstration of American power, respond as I believe they will, North Korea will be de-fanged. The result will be a boom in the South Korean stock market, as the discount on shares for possible war and mayhem will shrivel significantly.

For those investors prescient enough to discern them, the war has also brought two potentially profitable trends. The first is a sharp decline in crude prices. As I write, June crude is trading lower by 29 cents at $26.20 a barrel on the expectation that Iraqi crude exports will rapidly return to the market.

Crude was not alone in its descent; after its impressive rally on the battlefields, the U.S. dollar has also taken a turn for the worse. In fact, the dollar, which has long been joined at the hip to the stock market, has weakened and diverged from equities. Since Saddam’s statue was toppled in Baghdad on 9 April, the dollar has lost over 7% against the euro.

Mendacity: Stock Rally

Victory in Iraq did bring about one much anticipated sharp rally – in stocks. In fact, the victory rally was the first throughout the whole bear market to break indices above the 40-week exponential moving average. This is quite a bullish sign, although it does not necessarily herald the start of a new bull market. That is just one of a number of possible scenarios now playing out.

While it would be tempting to conclude that the “bull is back,” the problem is that gauges of sentiment do not read as they should for a true bull phase. In fact, bullish expectations, at 55.8%, are the highest they have been in years. Paradoxically, markets seldom rally when sentiment is too bullish.

That is not to say that a further rally is impossible. The market may continue to rise. It’s not as unlikely as your winning the Power Ball Lottery, but it could happen. Nonetheless, sentiment is too complacent at this level to make holding calls a comfortable strategy. There isn’t enough negative sentiment as reflected in the put/call ratio.

The critical test is right now. The market could continue to rise. But historically, 80% of the market’s gains are made between the months of October and April. The second and third quarters tend to be a more challenging time to make money in stocks.

It would be a stretch to presume that the whole seasonal strength has been Doppler shifted into the spring and summer this year. It remains to be seen if the political victory in Iraq will translate into gains for your pocket book.

Regards,

James Davidson
for the Daily Reckoning
May 13, 2003

P.S. Another reason for caution on the upside for the broader market is the sobering warning from Federal Reserve policy makers that weak growth poses a danger of deflation. In leaving interest rates unchanged on May 6, the Fed cited stagnant growth and intense competition as factors which are undermining pricing power. Generally, it is rare for stocks to perform dynamically when the corporate top line is declining. History suggests that stocks can’t stay up if prices for goods keep heading down.

Not the least reason is that there are few patient holders of stock when cash is too tight. When the typical investor is cash-starved, any holding which can be liquidated for value is…and the compounding of stock market gains is short-circuited at the margin. Consideration of this factor makes me more supportive of President Bush’s tax plan to slash income rates and reduce the double taxation of dividends.

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The stock market has lost its comic appeal. Gone is the zany joie de vivre of the late ’90s – when people expected to get rich overnight.

Now, they are no less wrong, believing that they will get rich slowly in stocks, but it is not as much fun to watch someone lose his money over a long period of time.

Besides, a slow, drawn-out bear market tends to include several longish stretches when stocks are not going down – but up. It is not unusual for stocks to rally for months…or even years…before finally reaching a bottom. In Japan, for example, the Nikkei Dow has staged 5 major rallies…while working its way down to a 20-year low and losing 80% of its value.

And whenever stocks rally, we begin to get email from gurus and pundits offering advice, such as this one:

“The stock market is already up 1,000 points…the biggest mistake you can make is to stay on the sidelines during this historic bull market…”

And, of course, there are the “I told you so’s” and the interviews with Abby Cohen…and all the people who think they are geniuses again, just because they guessed right. The latest polls by Investors Intelligence show 55.8% of advisors are bullish while only 24.4% of them are bearish. It is a bit tedious…and even unfunny…when the majority of these clowns are right, even for a week or two.

But thank God we still have bonds and the dollar. Over the weekend, the Treasury Secretary let it slip that the U.S. wouldn’t mind a lower dollar after all.

“Foreigners still shunning dollar assets,” says a headline in the Kansas City paper. What surprises us is not that they shun it, but that they ever got so friendly with it in the first place. On a trade-weighted basis, the dollar gained 47% from ’95 to 2002. So far, reports Stephen Roach, it’s only down 9%. Which leaves plenty of room for a lot of people to lose a lot of money.

The Fed and the Treasury are doing all they can. The latest week shows the money supply (as measured by M3 for the technically-inclined reader) up $55.4 billion. If this were to continue, M3 would grow by more than $2.5 trillion in the next 12 months.

Still, bond investors think they can make money – or even stranger, they think they can protect themselves from losses – by buying a long-term investment yielding scarcely more than inflation, at a time when the Fed is doing all it can to destroy the currency in which it is denominated.

And Americans, generally, believe they can muddle through a major decline in the dollar with no loss to their own wealth…or living standards.

“We continue to believe that a sharp depreciation in the value of the dollar,” writes Stephen Roach, “is the single most important force that might foster a long overdue rebalancing of a U.S.-centric world economy. The impacts of higher real interest rates should show up first in the form of weakening U.S. domestic demand – a key outcome if America is ever to rebuild its aggregate saving rate back to historical norms.”

Synopsis: A higher dollar = less spending = more saving.

Vulgate version: Americans are going to have to stop buying things they don’t need with money they don’t have provided by people they don’t particularly like.

Implication: More recession coming.

Eric, your news please…

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Eric Fry with the latest from Manhattan…

– “Honey, I Shrunk the Dollar” – the wacky, madcap monetary comedy co-produced by Ben Bernanke and Treasury Secretary Snow – has enjoyed a very long run. The show’s story line may have become a bit tedious to foreign audiences, but it continues playing to rave reviews from the lumpenivestoriat here in the States.

– Yesterday, even though the dollar tumbled to a fresh four-year low against the euro, the Nasdaq soared to a new 11-month high. The greenback fell 0.7 percent to $1.157 per euro, thanks, in part, to wacky comments by Treasury Secretary Snow in an ABC-TV interview over the weekend. During an appearance on “This Week”, the Secretary applauded the weak dollar for the helpful influence it imparts to our balance of trade.

– But the withering dollar didn’t bother stock market investors in the least. They turned a blind eye to the currency market while rushing in to buy their favorite over-priced stocks. The Nasdaq jumped 22 to 1,542 and the Dow soared 134 points to 8,738. The message is clear: As long as the PRICE of dollar-denominated stocks and bonds is rising, U.S. investors don’t seem to care that the VALUE of dollar-denominated stocks and bonds is falling.

– Government bonds also posted modest gains yesterday, with the 10-year Treasury note advancing a 1/4-point to yield 3.65%. The bond market’s continuing rally in the face of a collapsing dollar is even more amazing than the stock market’s rally…How – the bond-skeptics wonder – does a 10-year, dollar-denominated bond yielding a paltry 3.65% cohabitate with a central bank as overtly committed to currency-debasement as the U.S. Federal Reserve? Why would anyone want to buy one of Uncle Sam’s long-dated bonds? James Grant may have said it best when he referred to Treasury’s long-dated bonds as investments that offer “return-free risk.”

– When the Treasury Secretary of the United States cheers a weakening dollar, it’s time to consider bartering for seashells. What chance does the dollar have when its principal stewards are rooting for it to decline in value? How can the dollar possibly advance when it must navigate the Scylla of reckless musings by Federal Reserve governors and the Charybdis of irresponsible remarks by Treasury Secretary Snow?

– Over on Wall Street, the stock market bulls blithely proclaim that the feeble dollar is a great thing for stocks because it makes U.S. multinationals more export- competitive. “The greenback’s collapse can and will stimulate better earnings for companies exposed to business outside the U.S.,” chirped Tobias Levkovich, institutional equity strategist at Smith Barney in a research note to clients.

– We are not convinced. We suspect that a plummeting dollar is not a good thing. In fact, we would not be surprised if a collapsing greenback turns out to be a bad thing – both for the economy and for the stock market…

– As we noted last week in the Daily Reckoning, technology stocks are soaring, even while tech sector employment is contracting. How could this be? Part of the reason, of course, is that investors HOPE conditions in Techland will be improving as we head into the second half of this year. Another part of the reason for the tech stock rally is that armies of Wall Street “analysts” are forever predicting resurgent IT spending, and therefore, resurgent tech company earnings.

– It matters little that the oft-advertised tech sector recovery fails to materialize. As long as Wall Street storytellers tell their happy story, investors will continue to line up to buy tech stocks. But what happens if the pinstriped storytellers lose their jobs? Who then will spread the myth of the recovering tech sector? Who then will urge gullible investors to buy overpriced tech stocks? Many storytellers are out of work already.

– U.S. securities firms cut 80,400 jobs in the 22 months leading up to February 2003, according to the Securities Industry Association. That’s more than 10 percent of the peak employment levels. The New York City securities industry has suffered an even more painful 20% loss. For the moment, the Nasdaq is rallying briskly. But the earnings-challenged high-tech index can ill afford to lose more of Wall Street’s storytellers.

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Bill Bonner, back in Paris…

*** Gold rose $3 yesterday. Twenty years ago – when stocks were at an historic low, and gold at an historic top – you could cash in a single ounce of gold and buy all thirty Dow stocks, and still have change left over. A couple of years ago, we passed another milestone – an historic low for gold and an historic top for stocks, when it took 42 ounces of gold to buy the Dow. Stocks are less expensive, and gold more dear, than they were in 2000. But it still takes 25 ounces of gold to buy the Dow. Our guess is that you’ll be able to buy all 30 Dow stocks for one ounce of gold, once again, before this episode is over.

We don’t know how or when we’ll get there…but our “Trade of the Decade” – sell stocks, buy gold – still looks good.

*** The sun is shining. Church bells are ringing. It is another beautiful day here in Paris. But it is supposed to be “Black Tuesday.” A nationwide strike by government employees has paralyzed the nation. The subway, hospitals, and post offices are closed.

The chair-warmers are annoyed because they are being threatened with reform. Like perhaps every country in the developed world, France has promised its retirees more than it can deliver. In the public sector, which is 25% of the workforce, people can retire at age 55, or even 50 for some of them. Now, the government is proposing to force government employees to work two-and-a-half years longer before drawing retirement benefits. Jean-Pierre Raffarin, France’s Prime Minister, went on television the other day. In a masterful teary address to the nation, he spelled out why the current pension system cannot survive and asked citizens to cooperate. Strikers hope to force Raffarin to back down.

What a lovely day for a showdown. The streets of full of people walking…bicycling…roller blading…scooting along. Too bad…this afternoon, it’s supposed to rain.