Is War Bullish?
“It is easy to criticize,” said Elizabeth, letting me know that my views are as irritating at home as they are to many Daily Reckoning readers.
“What we’ve learned is that it is a dangerous world,” she continued. “And if we can make it any less dangerous by going after a gang of murderous barbarians in Afghanistan, we should do so.”
Polls show that 91% of the people of America agree with her and with President Bush. Recent surveys in Europe show sentiment here not too much different – with 79% of the British ready to back the U.S. and 72% of the French. Curiously, Germans are more reluctant. Only 52% of them want to get involved.
Perhaps enthusiasm for military campaigns is as cyclical as it is for junk bonds and bubble stocks. The Germans took such heavy losses in WWII that they have had little interest in beating the war drums since.
The Russians, meanwhile, have vivid recollections of war in Afghanistan. Their advice is clear: fighting a ground war in Afghanistan is a form of suicide.
But war has been proclaimed…and now it must be pursued. Will it make the world safer? Or less safe? We may never know. For whatever happens, we will never know what might have happened otherwise. That is why it is so hard to learn from politics…we can know what happens, but not why.
We merely note, for the record…and just to annoy readers…that war fever, like market fever, has a way of generating its own reward. The Austro-Hungarian Empire felt not only justified, but duty-bound, to demand satisfaction after its archduke had been assassinated by terrorists in 1914. And what self- respecting nation could ignore its treaty obligations? If Serbia went to war, Russia must too. And if Austro-
Hungary found itself in bellicose circumstances…France and Britain must be drawn in too. And then, though no one wanted it or asked for it, the whole world was at war.
By September 24, 1914, trench warfare had already begun on the Aisnes. And a single battle of this new war – Verdun – would cost the lives of 700,000 soldiers.
But here at the Daily Reckoning, we will confine ourselves for the present to following the money. It is often said that war is bullish…and it is widely predicted that, when the shooting actually begins, the U.S. will get the shot-in-the-arm…that glorious, heaven-sent wound…that sends us home and puts us back on the road to prosperity.
Could it be, dear reader? Could the world be such a paradoxical mess that you can get richer by destroying lives and property? If that is true, the terrorists’ attack must rank as one of the greatest risk/reward investments of all time. At trivial cost – maybe $200,000 – they did $60 billion worth of damage. Will nature, in her inscrutable majesty, allow us to build a boom on these ruins?
We are not so immodest as to set out to answer that question. But, in the rest of this letter we will at least toy with it…
“The stock market is more than 17% undervalued,” says this week’s Barrons. “It’s time to Buy Stocks,” screams the headline, illustrated with a comic drawing of an enraged bull with a U.S. flag tattooed on his arm.
The article, written by Michael Santoli, claims that stocks are undervalued based on the Fed Model, which compares the earnings of the S&P 500 to the yield on 10- year Treasury bonds. “For the next 12 months, the collective earnings of the S&P 500 are expected to be $55 a share,” writes Santoli. He then does the math to show that the earnings yield on the S&P would be higher than the 4.68% yield on Treasuries.
Where does this $55 come from? It was Ed Yardeni’s guess for earnings in 2002…current earnings are below $40. Thus, Yardeni expects S&P companies to increase their earnings by more than 30% from this year to the next.
This seemed like a preposterous dream a couple of weeks ago. Now, it seems merely unlikely. The economy is slowing down, not speeding up. Earnings would probably have been lower next year than they are this. But, with the winds of war at the economy’s back, anything is possible, right?
Last week, Barron’s looked at 9 international crises since the end of WWII. In only one case – the Berlin Blockade – were stocks still down one year later, and then only by 3.3%. In every other case, stocks went up – from a minimum of 7.2%…to a maximum of 42.2% in the 12 months following the Oil Shock of 1973. Two years after the event stocks were higher in all cases…from a minimum of 3.1% following the Gulf of Tonkin crisis in ’64 to 66.5%, again following the Oil Shock of ’73.
Looking more carefully at the details, we observe that most of these events had the good fortune to coincide with what was otherwise a modest point in stock market history. We see no instance of an external shock coming at a point when the market sat precariously on a pinnacle of prices, following an 18-year boom. Instead, each instance seemed to come along at a favorable moment…when the force of an impact might just as well drive prices up as down.
In the entire post-WW II period, the U.S. economy and stock prices climbed a mountain of rising valuations (interrupted by major valleys and countertrends from time to time). After the Great Depression and WWII, stocks were cheap…the economy boomed…and people became more and more confident that the future would be brighter than the past. Gradually, their habits changed as they became more and more confident – they spent more and saved less, and bought more and more U.S. stocks, which they had come to see as the greatest moneymaking investment they could make.
As time went by, the Federal Reserve became better and better at aiding and abetting the process of confidence- building. Our central bankers learned – thanks to Keynes and Friedman – that times of crisis needed more active management…and that each shock should be an occasion for introducing more money to the system.
On Wall Street, as perhaps in the rest of life, nothing succeeds like excess. If a few dollars could help stave off a crisis…a few more could trigger a real boom. Thus did the Greenspan Fed go about its work in the aftermath of every crisis to come its way – flooding the world with cash and credit.
As long as the big boom was in place, the extra money was taken up and used to expand demand, boost production, and puff up asset prices. Each time – especially, following the LTCM, Asian currency, and Y2K threats – the economy boomed and the stock market soared.
Most recently, central banks injected $208 billion into the world banking system immediately following the terrorists’ attack. The Fed and the ECB each cut another half of a percentage point from key lending rates.
Will the magic work again? Is it the same world it was in 1948 and 1998? Or has something really changed? Have we crossed some sort of watershed, such as people did in Japan in 1989…or in Europe in 1914…so that the habits of the last generation no longer produce the samelevel of prosperity…or the same peace?
We will see, dear reader, we will see.
September 24, 2001
The market will rise at the sound of gunfire.
That is the bulls’ great hope. And maybe it will. Prices have fallen on 13 of the last 16 trading days. The Dow is down 2,200 points. Addison calculates that this represents a loss of $46,200 per stock-owning household.
“We are now in the grips of a full fledged global financial crisis,” writes Doug Noland. The Paris market is down almost 40%. Brazil is down 30%. Japan is down nearly 30%. And Germany is down more than 40%.
“The business world is simply covered in a blanket of hesitation,” remarked a spokesman for data storage company EMC, explaining why it will lose money in the 3rd quarter. “Dazed companies sit on their wallets,” adds the NY Times.
A few weeks ago, investors were rushing to the big cap companies for safety. Now they are fleeing them, again, for safety reasons. Microsoft, once at $119, is now on sale below $50. Cisco, once $81, can be yours now at prices below $12.
Housing starts fell 6.9% from July to August – suggesting that even the real estate bubble is beginning to deflate.
But when the shooting starts, many believe, stocks will rally ’round the flag. And maybe they will. It is rare for stocks to go down this much without either 1) a panic to the downside, or 2) a big rally. Anything could happen, as they say, and anything will. More below…
Eric, what’s going on in Manhattan?
Eric Fry in New York:
– To judge from yesterday’s sparse attendance at my church, faith is a little less fashionable now than it was last week, when a standing room only crowd packed into the sanctuary for the 10:00 AM service.
– Meanwhile, a friend of mine who owns a number of very trendy bars in Manhattan, Los Angeles and elsewhere reports that his business is rapidly returning to normal. “Immediately after the WTC attack my bar business in Manhattan dropped about 60%,” he says. “Last week, it was off about 25%. But it looks like this weekend we might be getting back to the pre-attack levels.” His business elsewhere in the country has not dropped off one iota since the attack.
– Empty churches and full bars suggest to me that Americans are getting back to the business of self- indulgence. Can an economic recovery be far behind? Just as foreign nations should never underestimate America’s will to fight, economists should never underestimate America’s “will to consume.”
– My prediction: GDP will fall in the third and fourth quarters. In fact, the fourth quarter might be especially dismal. But some kind of sharp but fleeting recovery will likely materialize in the first quarter of 2002. All the recent stimulus from the Fed ought to get us at least one decent quarter before things turn sour again.
– The Dow tumbled 14.3% last week – the steepest one- week decline since July 21, 1933 when the average slumped 15.5%. Furthermore, the market’s eight-day string of consecutive losses is the longest such slide since 1989.
– “Some folks would say this has been a horrendous week for the market,” writes C.A. Green, investment director of the Oxford Short Alert. “I call it a ‘short-sellers’ rally.” Indeed it has been. But the selling looks like it may be starting to exhaust itself. The Dow’s bounce last Friday morning from down more than 300 points to up about 60 points could have been a preview of the week to come.
– The extreme VIX Index readings at present indicate that some kind of rally is imminent. This index, which measures option volatility on the S&P 500 index, is currently registering high levels of fear. Often, such readings precede rallies. I repeat, “often” – as in, not always.
– Perhaps the news that we have commenced some kind of military action in Afghanistan will spark the rally. Americans, for whatever reason, seem to get into a stock-buying mood whenever our military lashes out at our enemies.
– “Giving Terror Inc. its own Ground Zero won’t bring back the dead or secure a quick and painless victory,” writes Smartmoney.com’s Igor Greenwald. “But it would certainly cheer up the millions of investors wondering how that patriotic market rally [they had been expecting] turned into the Battle of the Little Bighorn.”
– Historical precedent might also shed some light on the market’s likely direction over the next few weeks. Then again, it might not, says Grant’s Investor’s Andy Kashdan: “Financial markets are no strangers to catastrophic shocks to investor confidence. To bring the historical record into view, Ned Davis Research has looked at 28 different crisis events dating to the fall of France to the German army in 1940. Although the Dow Jones industrial average dropped immediately after most of the events, the Dow on average had gained 12.1% after 126 days.”
– But as Kashdan points out, “Crises naturally come at different points in the business cycle, and that variable adds to the difficulty of predicting future outcomes based on the past…Even before the recent tragedy, consumer sentiment had plunged, the unemployment rate was higher than expected, and profit warnings were plentiful.”
– Furthermore, as Paul Kasriel, director of economic research at Northern Trust Co., recently reminded us, the S&P 500’s decline from its 2000 peak still leaves it more overvalued than in any other postwar recovery period.
– “The lesson that we take from economics and from market history,” Kashdan concludes, “is that, for better or worse, the path on which the United States economy was traveling before last week’s attack will not be so quickly changed.”
– “The event is on. And it could be the most important gathering we’ve ever held in our 20-year history,” writes Kathleen Peddicord, editor of International Living. The event? The Agora Las Vegas Wealth Symposium, from October 31-November 3, 2001. The gathering is little more than one month away and it ought to be very interesting. “We’ve all been through a lot these last couple of weeks…[but] it’s time to make some hard decisions and to take action to protect our financial future.” (Call Agora Travel for details: 1-800-926-6575 or 1-561-266-6570.)
Back in Paris…
– Seven people were arrested over the weekend for planning to blow up the American Embassy here in Paris.
– Meanwhile…”I don’t know if this is true or not,” ventured our friend Yves at tea yesterday, “but the French press says that George Bush is not very smart. He thought the Taliban was a rock and roll band…and he didn’t know who the president of Pakistan was. Of course, I don’t know who it is either.”
– “Look,” I replied, defending our president, “most people couldn’t tell the difference between the Grand Mosque and an Exxon station. But so what…that’s why we have GPS on our bombers.”