Compounding the Pain

Guest essayist James Dale Davidson ponders the state of airline security and suggests how you may be able to benefit from a technological response to Terror.

"The power to hurt – to destroy things that somebody treasures, to inflict pain and grief – is a kind of bargaining power, not easy to use but used often. In the underworld it is the basis for blackmail, extortion and kidnapping, in the commercial world, for boycotts, strikes and lockouts…."

– Thomas Schelling

I scarcely need add that in the political world, "the power to hurt" is the basis for terrorism, as brutally evidenced by the attacks in New York and Washington on September 11. Welcome to the new world of Vantage Point investment. Unhappily, it is a world in which homicidal lunatics are dedicated to using "the power to hurt" in imaginative and ruthless ways. Recognition of this fact should figure in your investment strategy.

Four months on, it is evident that Americans are prepared to go to considerable trouble and expense to
forestall a repetition of deadly terrorist attacks. As usual, however, there is broad public misunderstanding
of the underlying issues involved in preventing terrorism. For most people, "security" is a kind of
dignified synonym for "inconvenience," particularly where commercial aviation is concerned. The authorities
have catered to and reinforced this impression with their "more of the same" response to airport security.
In the days and weeks after September 11, heightened domestic security, especially at airports, has been of
decidedly low tech character, involving inconvenience in multiple forms.

This was manifested in one important way through the blanket cancellation of flights. As of November, the
most recent month for which figures are available, international air service, both in terms of the number
of flights and seats occupied, was down appreciably in selected U.S. airports. The drop in the number of
flights ranged from about 20% in Detroit up to 80% in Washington, while the number of seats occupied fell by an average of about 40%.

The decline in the number of passengers no doubt partly reflected an intensification of the annoying and mostly pointless security rituals to which travelers in the U.S. have been subjected for decades. These now involve feats of juggling that would challenge the dexterity of the multi-armed Hindu deities. Every passenger must brandish his laptop, while simultaneously emptying his pockets, opening his carry-on bags, showing his ticket, along with a passport or driver’s license, while still gripping any reading material or refreshment he wishes to carry aboard an airplane, all while passing through a gauntlet of metal detectors and x-ray machines. The nuisance value is substantial. The security enhancement, doubtful.

I don’t know about you, but I seriously doubt that a United flight from Miami to Washington Dulles was a smidgen safer after an ill-tempered security screener confiscated nail clippers from the Dopp Kit in my carry-on luggage.

The strategic risk posed by nail clippers eludes me. I can’t imagine using them as a weapon. Some muggers once assaulted me on the streets of Baltimore. I was not carrying my nail clippers. But had I been, I doubt that they would have stumbled away in panic. "No man, be cool. We was just joking. Don’t use those nail clippers on us." I have a good imagination, but I can’t picture the scene where a would-be hijacker takes over a plane with nail clippers: "Stand back. Either you let me take over this flight – or I am going to give you a bad manicure."

Granted, if someone tackled you and held you down, he could no doubt inflict a wicked scratch with a nail
clipper. If it were rusty, maybe he could even give you tetanus. But the nail clipper’s usefulness as a weapon
is limited, especially compared to other items commonly found on airplanes. You could break the barrel off a wine or whiskey bottle and have a truly lethal weapon. Even the metal forks which are still allowed on board are much more potent weapons than nail clippers.

Make no mistake, I am not advocating that wine bottles or forks be removed from the flight cabins. Neither do I imagine that it is possible to screen out every possible weapon that might be used by a determined lunatic. Witness Mr. Reid’s running shoes. If every executive wishing to fly to Washington or New York were required to strip down to his skivvies, or even forced to parade naked like a suspected heretic being interviewed by the Inquisition, flying could be made more unpleasant still, without adding one iota to its safety.

Osama bin Laden set out to inflict damage on the American economy. He succeeded outright in destroying
the World Trade Center, and damaging the Pentagon. His success has been compounded indirectly because we have abetted his mission by imposing a punishing productivity tax on ourselves in turning back the clock on transportation efficiency. What could and should be a 40 minute flight has been turned into a four hour ordeal, due to cumbersome, low-tech security measures.

While people will tolerate a lot of inconvenience in the full blush of patriotism, in the fullness of time they
will ultimately begin to grumble when the inconvenience is pointless.

Such is the situation now in airport security. The key to actually improving safety is not inconveniencing and
humiliating non-hijackers, but distinguishing the homicidal maniacs from the rest of us who pose no
risk. In this respect, I feel that it should not be immaterial to United Airlines that I am a 100,000 mile flier in their Mileage Plus program. Presumably, if I have flown that many miles with them I have established
a history of not posing a danger to the flights I boarded. And further to that, I am an Episcopalian.
Never, in the history of the world, has an Episcopalian hijacked an airplane. In a better world, you and I would be recognized as law-abiding persons. And waved through.

The current airport security system cannot do that because it lacks both memory and discernment. In a novel application of the "equal protection clause", the system is organized as if there were an equal probability that the president of IBM and an Arab drifter would prove to be suicide bombers. In reality, the matter is very different. There is a great deal of information available about most people which makes it predictable, to a high degree of confidence, that they do not pose security risks. Given that there are opportunities to update the data, there is no more reason to frisk executives who fly constantly than there is to pour out all the Diet Coke set to be loaded aboard a plane in order to test it for poison.

Yes, terrorism is awful, and it poses a real danger, as the events of September 11 underscored. But if we
inflict an ongoing punishment on every traveler in an attempt to avoid a repetition of those events, we are
merely compounding the hurt that our enemies intended to impose upon us.

The current security regime is the equivalent of slowing down auto traffic to 5 miles per hour in order to
prevent fatalities. Yes, it would "work." Auto deaths would recede to the vanishing point, but at a cost greater than the good achieved. Instead of subjecting everyone to extended interrogation by high school
dropouts, many of whom can scarcely speak English, a rational security system should focus on identifying the persons who really pose a risk to others – namely, known lunatics and Islamic fundamentalists.

The question is how such persons can be recognized. Can we afford to hire security guards who are smart enough to memorize the faces of millions of persons? No. We can’t. But we can harness biometric face-recognition technology that can identify millions of persons instantly, within a small margin of error. This will be the basis of a new industry, not limited in its application to identifying terrorists, but propelled
into more rapid growth by the heightened concerns about security that high profile acts of terrorism have
underscored.

Face recognition technology has a tremendous potential to enjoy rapidly growing demand. According to the
International Biometric Group, total worldwide sales for biometric identification systems were US$58.4 million in 1999. By 2003, sales are expected to leap by a full magnitude (tenfold) to US$594 million. Market research firm Frost & Sullivan projects a further surge to $900 million in revenues by 2006. These forecasts are conservative. They were all made prior to September 11. With demand likely to multiply because of enhanced security concerns and major breakthroughs in applications, actual sales could far exceed these
projections.

In short, the biometric facial recognition market is likely to grow at a rapid pace for the next few years. This creates precisely the situation in which fortunes can be made by passive investors.

James Davidson,

for The Daily Reckoning
January 09, 2002

James Davidson is a graduate of Oxford University, a renowned author and venture capitalist. Mr. Davidson’s articles have appeared in The Wall Street Journal, Investor’s Business Daily, The Washington Post and USA Today. He has been a guest on MacNeil Lehrer, Firing Line, Today, Good Morning America, Larry King Live, and John MacGlaughin. He currently sits on the boards of over 20 thriving technology-driven companies, and has been invited to join Merrill Lynch’s technology advisory board.

Editor’s note: You may know Jim from his books The Great Reckoning and The Sovereign Individual or from his ground-breaking work with Strategic Investment. For a discussion of his latest venture, Vantage Point Investment Advisory, and his investment philosophy since departing the bear camp.

Mortgage payments slipped. Bankruptcies soared. Credit quality fell. Moody’s reports the "biggest drop since 1991" in corporate credit quality.

People got poorer in 2001. But they did not get much wiser.

"Record Increase in Consumer Borrowing," announced an AP headline yesterday. Lured onto the rocks of debt by the sirens of zero-interest auto financing, deep discounts, low prices, and incentives, consumers borrowed more money in November than at any time since they began keeping records in 1943. Consumer debt rose 4 times faster than economists had expected…an increase of $19.8 billion.

In a better world, people might learn the lessons of a recession without the pain of losing jobs, cutting
back, and making do. But ours is still a world of sin and sorrow. And thank God! How boring it would be
without sin. And how tediously cheerful people would be without an occasional bout of sorrow to sharpen their wits and dull their pride.

Yes, it is true. While most of the world pins its hopes on a recovery…we here at the Daily Reckoning
long for a deeper recession. Not that we like to see people suffer – and especially not ourselves…but we’ve
never met a man who wasn’t nicer, wiser and more companionable after a real setback. And we have never
heard of a real recovery without a real bust preceding it. Our complaint about the slump so far is that it
hasn’t been real enough. That is why people still add to their debts – even in the 9th month of a recession. And why people cheer as stocks rise…even though profits are still falling.

"We’ve seen enough bear markets to know they invariably end in tears, not cheers," writes Alan
Abelson of Barron’s. At the end of a real setback, he continues, "investors, rather than nursing illusions of
recouping their losses in the market with a fresh cut of the cards, are completely disillusioned with stocks:
They don’t want to think about them or hear about them, much less, heaven knows, invest in them."

But Americans are still eagerly investing in stocks, aren’t they, Eric? (A reminder, Eric is hosting
CNNMoney every morning this week…tune in 9:30 to 11:30am on CNNfn…)

*****

Eric Fry in New York…

– It was a sloppy day on Wall Street yesterday. The Dow shed 46 points to 10,150, while the Nasdaq gained almost 19 to 2,056. AOL Time Warner set the tone for the day’s trading with a downbeat earnings forecast.

– Remember the euphoria that surrounded the AOL Time Warner merger when it was first announced, about two years ago? What a Wall Street lovefest that was!

– Back in January of 2000, I wrote in Grant’s Interest Rate Observer, "AOL’s lavish valuation is the love child of passion and momentum. Cold, hard securities analysis has no more to do with its fair value or share price than a biology textbook does with a one-night stand… Even in the context of prevailing stock market fashions, the valuation of the AOL/TWX entity is extravagant.

– "The merged entity will likely display all the agility of an elephant on Quaaludes…Sell the beast." Since
then, the stock has plummeted about 52%.

– Funny how often it pays to play it safe. But investors are doing anything but playing it safe these days.
Speculation is "in," and it might prove to be just as hazardous to your portfolio’s health as it was in 2000.

– When I was appearing on CNN Money yesterday, J.P. Morgan strategist Douglas Cliggot made a very persuasive argument that S&P earnings growth in 2002 would be ZERO. His reasoning in brief was that we would see lower earnings in the first half of the year, balanced out by higher earnings in the second half, for no net gain.

– "Once this reality sets in," Cliggot said, "investors might become a little disappointed." Well said, Doug.

– The cautious Cliggot is at odds with his chronically bullish counterparts like Goldman’s Abby Joseph Cohen, who’s looking for blockbuster earnings growth of 30% to 48%. A prediction: One of them is wrong…I nominate Ms. Cohen.

– And of course, Cohen is bullish – yawn – on stocks.

– "We think there is still significant opportunity in technology," Cohen let slip in a recent New York Times
interview. "[And] we think that this is an environment that will be good for well-managed financials."

– The interviewer then addressed Morgan Stanley strategist Byron Wien by asking, "What should we avoid
now?" Wien replied, "Tech and financials." A second prediction: One of them is wrong. I nominate Ms. Cohen
again.

– Abby Cohen seems so thoughtful; it’s hard to believe her investment advice is so reckless. But thanks to
Abby, and others like her, investors are returning to their favorite speculations – like the quadruple-bypass
patient who lights up a cigarette on the ride home from the hospital.

– But didn’t the ferocious NASDAQ collapse over the last two years teach investors to avoid risky overpriced
stocks? Well…ah…not exactly. Speculating is much more exciting than collecting interest payments. Like
dieting and exercising, investing prudently can seem rather dull while you’re doing it…no matter how good
for you it might be.

– It’s much more thrilling to buy the shares of profitless companies like Riverstone Networks that have
soared more than 300% from their autumn lows.

– "Scarred but largely unbowed, [individual investors] say the stock market is still the place to be," the New
York Times reports.

– Perversely, the more that industrial America seems to struggle, the more stocks seem to rise. That can be a dangerous divergence.

– Here’s why: Profit margins are collapsing in sync with the rate of capacity utilization, says Moody’s John
Lonski. Profit margins have collapsed since the end of 1997, as capacity utilization has also collapsed to its
lowest level since 1983. And it is still falling! That does not bode well for earnings growth.

– Mounting job losses in the manufacturing sector provide further evidence that capacity utilization will
not be improving anytime soon. Manufacturing jobs took it on the chin in December with a loss out of 133,000 jobs. Furthermore, the manufacturing sector lost 1.3 million jobs during 2001 – the third consecutive yearly decline of manufacturing employment, according to Northern Trust economist Paul Kasriel.

– The American manufacturing base is moving so rapidly toward extinction that within a few years there’ll be only two kinds of Americans: Those who make Starbucks cappuccinos and those who buy them.

*****

Back in Paris…

*** Unlike most investors, we like to buy our investments when they are cheap, not when they are
expensive. And it’s been a long time since we could buy a share of a major U.S. company at a bargain price.

*** Lately, many stocks seem to have returned to irrational exuberance levels.

*** EMC is priced at 510 times hoped for 2002 earnings. If you want a share of Cisco, you’ll have to pay 94
times earnings. Intel is at 74 times earnings. And Applied Materials will cost you 214 times earnings.

*** PMC Sierra, another tech wonder stock, has no earnings upon which to leverage a P/E ratio… still, it
is priced as though the company were worth $4 billion.

*** We wonder what investors could be thinking. Profits would have to soar in the tech sector to make these
prices seem sensible. But why would profits soar? Doesn’t every company already have plenty of IT
capacity? Is there no competition in the tech sector to keep profit margins down? Didn’t a recent McKinsey study show that IT spending had no beneficial effects on productivity?

*** Buying these stocks isn’t investing. Nor even speculation. And calling it gambling is flattery. It is
financial suicide. I’ll explain why in an upcoming letter.

*** Lynn Carpenter, whose track record I mentioned yesterday, is a Buffett fan. She studied the methods of
the Sage of the Plains and applies them in her own investment recommendations. But she thinks she can do
better than Buffett, largely because Buffett has gotten too big for many value opportunities and he is watched so closely that few bargains remain after people suspect he has an interest.

*** "So, how did you do compared to Buffett?" I asked.

Her reply: "Buffett did almost as well as FSL [Lynn’s newsletter, the Fleet Street Letter]. Berkshire went up
32.4% in the two-year period, just a little behind our core portfolio (34.4%). But Berkshire fell far behind
the combined 51% we made across all three FSL portfolios – the core, 10-for-10 and high-yield results together."

Bill Bonner