Deciphering the War Drums

Despite a year of political grandstanding, says Vantage Point’s Jim Davidson, most of what has been done or proposed during the so-called “War on Terror” was conventional, even anachronistic.

“Experience is a hard teacher because she gives the test first, the lesson afterwards.”

– Vernon Law

The scuttlebutt in Washington has escalated to a fever pitch. President Bush’s speech last night laid out his case to the world for a war which could begin in a matter of weeks. This imminent threat raises important questions, not the least of which is what will war with Iraq mean for your investments?

This is a question I’ve spent a lot of time mulling over. I have an extensive amateur education in military history, and have also spent years thinking about the impact of strategic developments on investment. Beginning two decades ago, I joined with Lord William Rees-Mogg, former editor of the Times of London, to undertake what proved to be a long-term effort to analyze markets based on the dynamics of conflict. We delved deeply into the history of military technology to see how the changing balance between offensive and defensive weaponry had altered economies and social organization. The results of our research were published in Strategic Investment, and in three books, Blood in the Streets, The Great Reckoning and The Sovereign Individual. I came to believe that the largest ponderable factors in the unfolding of history are the influences which determine the costs and rewards of projecting power.

Looking at history through that prism, we saw the development of the microchip as more subversive of large-scale governance than any political tract ever penned or the scribblings of any defunct economist. I saw dark possibilities arising from the influence of decentralizing technology in devolving military capability to small groups.

Lord Rees-Mogg and I got more press for having foreseen the collapse of the Soviet Union, which occurred while our books were still in print, than for warning of an upsurge in terrorism. At that time, terrorism was just a cloud on the horizon, not a towering inferno in downtown Manhattan. Yet notwithstanding the fact that our forecasts about terrorism were ignored a decade ago, they were arguably prophetic of the headlines over the past year. Consider this passage from The Great Reckoning:

“A terrorist is unlikely to be deterred from employing weapons of mass destruction by the threat of massive retaliation. A mad bomber who would risk death to blow up an airplane is willing to risk death. Period. He is unlikely to be further deterred because his target is bigger. Indeed, the logic of terrorism makes it more attractive for terrorists to blow up or poison a whole city than to kill a few innocent tourists on an intercontinental flight.

“For fundamental reasons, weapons of mass destruction are more likely to be used, the greater the number and smaller the scale of the groups who can obtain them. The vulnerability of large governments and centralized targets is therefore likely to continue growing during the 1990s. Large cities rather than military targets will be at growing risk as effective weapons of destruction are dispersed ever more widely throughout the world.”

Events have unhappily proven that we were correct to conclude that “the threat of retaliation is of declining value in deterring the use of weapons of mass destruction as they proliferate.” This is directly relevant to the proposed military action to remove Saddam Hussein from his many palaces in Baghdad.

I am a firm believer that investment analysis should rest on a sound logical foundation. Without pretending that I am privy to any “inside” information from official sources in Washington, I ‘d like to lay out for you some of the possible implications of the Bush administration’s preoccupation with Iraq.

Bush and his advisers may not fully grasp the dynamics of the threat presented in battling an enemy like the al Qaeda terrorists. It is only too believable that the leaders of the “only remaining superpower” would be frustrated by the challenge of confronting a clandestine enemy who refuses to step out of the shadows.

Al Qaeda is a novel threat. Never has the United States faced such unconventional antagonists. Even the Barbary pirates who so appalled and preoccupied the administration of Thomas Jefferson were ordinary, rational beings compared to Osama bin Laden and his followers. The Barbary pirate states of Tripoli, Tunis, Morocco and Algiers preyed on shipping as a means to gain wealth from theft, ransom and extortion. Al Qaeda, by contrast, does not launch its depredations solely to accumulate wealth. If bin Laden had lived in a palace like the pasha of Tripoli, he would have been a much easier antagonist with whom to deal. The terrorist attacks of Sept. 11 were launched as destructive acts to injure and kill Americans and help radicalize Muslims around the world, not for pecuniary gain.

With that as background, the government’s response to the unconventional threat did little to encourage my optimism about a successful prosecution of the “War on Terror.” Most of what was done or proposed during the past year was conventional, even anachronistic. The United States launched a retaliatory war against Afghanistan. This did not require “outside the box” thinking about terrorism. For that reason, the fact that it was a success does not necessarily validate the strategic judgment upon which it was based.

The administration also heightened and intensified “bureaucracy,” in response to the crisis, by federalizing airport security and proposing a cabinet level “Department of Homeland Security.” Any student of modern history knows that intensifying command and control bureaucracies is the natural reflex reaction of any government facing a challenge. The fact that Bush and his advisers were so quick to propose a conventional response to an unconventional threat is not a good sign that they have a deep grasp of the dynamics of the problem. It would have been much more encouraging if President Bush had come forward and announced to the public that U.S. intelligence and military forces would henceforth be committed in a protracted Quiet War with terror involving new models of engagement, rather than reverting back to a Cold War mentality to fight a clandestine 21st century threat.

Another implication of the proposed attack on Iraq is that the Bush administration believes that the success of Islamic terrorism is based upon state backing. There is certainly some evidence for this. Afghanistan under Taliban rule provided a protectorate for al Qaeda terrorists. There are vague reports that Iraqi intelligence backed al Qaeda. Iran has reportedly provided sanctuary to some al Qaeda leaders. And other reports indicate that al Qaeda was partially funded by the Saudi government, which allegedly provided Osama bin Laden with lavish payoffs not to attack them. So the case that al Qaeda and Islamic terrorism in general depend upon state backing for success is not without some supporting evidence.

The question is whether the backing of states is crucial to the emergence of neo-medieval groups like al Qaeda that wield military power without exercising a dominion over a specifically delineated territory. Those who believe the answer is yes may be right in terms of any given terrorist act or capability. But I suspect that they are trying too hard to fit disruptive threats of terror into a well-worn pigeonhole.

Nation states know how to fight one another. They don’t know how to fight non-state threats. That implies a strong temptation to construe every threat as essentially originating with some rogue state rather than from outside the nation state system. If this is what Bush and his talented advisers think, which is probable, they could only be right temporarily. The logic of the power equation has long pointed to an escalating capacity of small groups to wield destructive force. This implies the twilight of state power and a growing capability of small groups to disrupt life as we know it.

By contrast, al Qaeda and the other followers of bin Laden are not contesting territory per se, except to claim moral dominion over Islamic lands. The Bush administration seems to want to counter the difficulties that the non-territoriality of terrorism poses by assigning a homeland to the terrorists first in Afghanistan and now in Iraq.

America has weapons which so far exceed the capabilities of those of any Islamic country that we could obliterate any force that can be identified as an enemy and is motivated to stand and fight. But the fact that we could obliterate any congregation of terrorists or any army by employing superior weaponry to that of the terrorists does not in itself mean that terrorists will be cowed if American armed forces wipeout another Islamic army.

Will such a tack succeed?

At the simplest level, the answer is probably no. Witness the intractable, clandestine violence that plagues Israel. The Israelis enjoy a vast military technology gap over the Palestinians. That is the very reason why suicide bombers and other Islamic fanatics have been moved to adopt violence by clandestine means. Terrorism is precisely the means of choice by which the highly-motivated weak battle the strong.

Like it or not, a policy for combating terrorism must take account of its impact in motivating fanatics as well as killing them. Therefore, a war against Iraq becomes more problematic if all contingencies cannot be carefully controlled in advance, something that even the talented tacticians at the Pentagon would be hard- pressed to guarantee. Much depends upon the actual conduct of the fighting, how bloody it is and how many civilian casualties are suffered. Every child or parent who dies and leaves behind a disconsolate relative is a potential recruiting agent for al Qaeda.

It is so obvious that an invasion of Iraq has the potential to inflame the tinderbox of Islamic lunacy that it deflects the question of what the Bush administration is thinking to another level.

Furthermore, the administration seems to believe that a swifter military victory is possible than many senior military officers seem to believe. An “abracadabra” victory would be great, if it could occur; it could enhance the security of the United States and the Western world while doing little to inflame Arab and Islamic fanaticism. But credible reports in Washington suggest that military planners worry that an attack on Iraq will divert intelligence resources, spy satellites, reconnaissance aircraft and Special Forces members who speak Arabic from anti-terrorist efforts in Afghanistan and other theaters of interest. Retired Army General Henry H. Shelton, recently chairman of the Joint Chiefs, said, “If we get drawn into something in Iraq, then our forces will go very heavily there, and it will be hard to sustain the momentum in the war on terrorism.” Finally, President Bush may believe that war is a tonic for slack demand and recession. It is widely understood that the New Deal remedy for the Depression that followed the stock market crash of 1929 did not really lift the economy back to its full potential. That did not happen until the United States entered World War II.

This year, for the first time since the beginning of World War II, the stock market seems set for three consecutive down years. I am sure that Bush and his advisers are hoping to see a strong rebound in the last two years of his term. I have no specific evidence that President Bush feels that military engagement is a tonic for economic downturn or doldrums in the stock market. But it is entirely possible that he does.

This could help explain the eagerness with which the Bush administration seems to be approaching an invasion of Iraq.

James Davidson,
for The Daily Reckoning
October 8, 2002

Editor’s Note : James Davidson has enjoyed great success founding new companies in a variety of industries. He’s a graduate of Oxford University, and a renowned author and venture capitalist whose articles have appeared in publications from The Wall Street Journal to USA Today. He currently sits on the boards of over 20 thriving, technology-driven companies. Davidson’s latest research and investment picks can be found in:

Vantage Point Investment Advisory

Stocks continued their orderly retreat yesterday.

Readers will recall that they began pulling back like Napoleon’s troops from Moscow – carrying the looted treasures of the great bull market.

But as the milestones pass, more and more of the booty is being tossed off. The Nasdaq, the “stock market for the next 1,000 years,” fell to a 6-year low yesterday. Day after day, week after week, month after month, year after year, the poor stock market grenadiers are being harassed, attacked and mauled.

After nearly 3 years of a bear market, most would feel lucky to be able to get out as they came in. But the weather is getting colder and the road is getting harder.

“There are times to stay away from stocks altogether,” says ‘Shrink Rap’ at (which is, surprisingly, still in business), “and as I see it, this is one of them.”

“Sauve qui peut…” the French hussards must have thought to themselves. But what could they do? Napoleon had already made his mistake. Now, the emperor had abandoned them and made his way back to Paris by coach relays. And there they were, still thousands of miles from Paris. The Russians had lain waste to the country…and temperatures were falling to minus 25 centigrade.

Still, America’s investment troops are disciplined. They’ve been trained by an 18-year bull market: never break ranks, hold the line; remember, you’re in for the “long haul.”

So, they fall back in good order…they do not panic, they do not run. And at any moment, they could still turn around and counterattack. So far, it has been surprising that their counterattacks have been so feeble.

But it is also surprising that they have not yet panicked.

Which leads us to think that bear market has a long way to go. Sooner, more likely than later, they will put on a decent rally…they will stand and fire, or even charge. Then, later, they will throw down their stocks in disgust. “Every man for himself,” they will think as they rush to get out. But few will make it. Stocks will plunge. The Dow could drop as low as 3,600…and the bear market will be over.

Napoleon invaded Russia with more than 300,000 troops. Fewer than 10,000 are thought to have made it back. Will Wall Street be less cruel than Moscow?

We will find out. In the meantime, the poor troops still have a long march ahead of them…God bless ’em.

Eric, your thoughts?


Eric Fry from the city of New York…

– The slaughter of innocents continues on Wall Street. The “buy-and-hold” regiment – standing shoulder-to- shoulder with the “buy-the-dip” battalion – charged into the fray yesterday, only to sustain massive casualties once again.

– The Dow dropped 105 points to 7,423, while the Nasdaq stumbled 2% to 1,119. Lest anyone needs reminding, the Nasdaq’s closing level yesterday is but the latest in a series of fresh six-year lows.

– “Are investors who leave money in the stock market deluding themselves?” the Wall Street Journal wonders. “It’s beginning to look that way.” The bubble-era Journal would never have dared to print such non-bullish musings. But in the post-bubble era, bearish musings are becoming quite fashionable. Once again, we at the Daily Reckoning find ourselves at the avant-garde of financial fashion…we can’t help it. Still, we suspect that a bearish perspective has not become so pervasive as to pave the way for a new bull market.

– Even if many investors profess contempt for stocks, SOMEBODY out there still loves them a lot. A stock market selling for about 30 times earnings is – self- evidently – not despised.

– “We are still in the aftermath of a major bubble,” says David Webb, a senior fund manager with Shaker Investments in Cleveland. “Those who leave money in the market are in denial.” The situation is perhaps not as bleak as Mr. Webb portrays it. Even in a bear market, some stocks are worth owning. The problem is, there are so many stocks that AREN’T worth owning, that it’s easy to make a mistake. But that’s what investing is all about – paying as little as possible for the shares of good companies, while avoiding altogether the shares of bad companies.

– This process has never been easy. But one thing is certain; no one learns how to invest during a bull market. When stocks are going up every day investors learn only one thing: that stocks go up every day. During bull markets, every stock purchase is a good idea, and every sale is a bad idea. (And a short-sale is an especially bad idea!)

– Only during mercilessly unforgiving bear markets do individuals really learn how to invest. And what they usually learn first is that it’s hard to make money, but very easy to lose it. Preserving capital is paramount.

– “Investors have to unlearn everything they have been taught about stock-market investing during the past decade,” the Journal relates. “The mutual-fund industry has been ‘promoting the dogmas of the ’90s: that you should be fully invested, that you should buy on the dips, that what matters is relative performance,’ Mr. Webb adds. ‘People are waking up to the fact that nobody told them how dangerous it was – and still is – to invest in the stock market.'”

– Many folks are responding to their newfound knowledge of good and evil by pulling entirely out of stocks.

– They’re deciding that patience is more likely to be a vice than a virtue when it comes to investing, and they’re pulling what’s left of their tattered nest-egg out of the stock market.

– “A milestone of sorts was reached in July,” the Wall Street Journal reports. “For the first time in 15 years, investors took more cash out of stock market funds than they put in during a 12-month period.”

– The exodus from equity funds has been gaining momentum. Much of this flight capital has set up camp in the Treasury-bond market – thought to be the Promised Land of capital preservation.

– According to AMG Data Services, investors yanked $51.1 billion out of stock funds during the third quarter and piled an unprecedented $49.5 billion in taxable bond funds. So far, selling stocks to buy bonds has been a good trade. Then again, selling stocks to buy bubble gum would have been a good trade.

– T-bond funds racked up a splendid 8.1% gain for the third quarter, according to Lipper Inc. The Dow Jones Industrial Average meanwhile, tumbled more than 17% over the same three-month span. It turns out that bonds have been dramatically outperforming stocks for quite a while. Morgan Stanley notes that U.S. government bonds have outperformed U.S. stocks by a staggering 56% since December 1999.

– “If you imagine the [stock] market as a mythical angry god that is demanding sacrifices of those who had long worshipped it, there is no way to guess when it finally will be appeased,” writes Tom Petruno of the Los Angeles Times. “It already has consumed the early-retirement dreams of some, the college funding hopes of others and the reputations of hundreds of corporate executives. But it may yet want more.”

– Indeed, the “mythical god” gives every indication of “wanting more.” But it may not be angry at all…merely sadistic.


Back in Madrid…

*** On my computer screen this morning an ad popped up – offering me an opportunity to subscribe to Mutual Funds magazine. But the news brings word that the magazine is shutting down – not enough ad revenue.

*** Gold went nowhere yesterday. It has gone almost nowhere for many weeks. So far, this is only a stock market problem; the monetary and economic problems have yet to be uncovered. When they are revealed, gold is likely to move. In the meantime, we are quite happy to go nowhere.

*** Consumer borrowing went up another $4.2 billion in August. And the mortgage industry, bless its heart, found yet another way to encourage consumers into insolvency – the Household Asset Management Account, we believe it is called. It is a new type of mortgage that allows homeowners to simply write checks against the ‘equity’ in their home. But when the ‘equity’ goes down, do they get the money back? We don’t think so.

*** The Nikkei Dow hit a new low yesterday. Nearly 20 years of stock market gains have been wiped out.

*** In the U.S., meanwhile, an investor would have been a lot better off in bonds than stocks since 1999. How long will this trend persist? We don’t know, trends have a way of lasting a lot longer than you think they should. More, as the Daily Reckoning continues… tomorrow…

Vaya con dios,
Bill Bonner