The God of War
A DR Classique originally broadcast a month and a day after the attacks on the World Trade Center and the Pentagon.
"Americans are walking right into a trap," said a friend at lunch the other day.
"Terrorists don’t expect to defeat the U.S. They know they can’t do that," he continued. "These people are not dumb…I lived among them for many years. They have a different idea of how the world works."
"They had a reason for striking the U.S." he explained. "It was very simple. They wanted to show the rest of the radical Muslims that they could reach right into the heart of the ‘Great Satan.’ More importantly, they wanted to provoke a response. As big a response as possible. They don’t care if they live or die. They will measure their success by the extent they set the world on edge and radicalize other Muslims."
Here at the Daily Reckoning our beat is money. But we look to the rest of life – love, war, poetry – for instruction. A man may be driven wild by love, or by war, or by a bubble market. He may act wisely…or foolishly…depending on the circumstance.
And he may be ruined or saved as often by grace of the gods as by his own perspicacity.
What turns our attention to war is the fact that we seem to be in one. And what causes us to comment is the fact that the nation’s bellicose spirit seems to have formed a grand alliance with its wishful bullishness. Thus are we drawn into the war by alliances…like Germany and Russia into WWI.
That war, too, began with a terrorist incident. Gavrilo Princip, too, wanted to stir things up…to provoke the authorities. He succeeded beyond his wildest dreams. By the time the war was over, the major monarchies of Europe had all fallen – the Hohenzollerns in Germany, the Romanoffs in Russia and the Hapsburgs in Austro- Hungary – and every major government of Europe had been replaced.
Ninety-three years later, Wall Street and the Pentagon march to the same drummer. Rumors that Osama Bin Laden has been captured or killed cause huge leaps in the stock market. In the group mind, the "war on terrorism" (the war of "infinite justice" has been quietly dropped…) is as certain as a bull market on Wall Street. It may take time. There may be ups and downs… but the inexorable march of history is towards higher prices on Wall Street and an American victory against terrorism.
We do not know better, or worse. But a victory over bear markets and terrorism is so widely anticipated and so little questioned that we cannot help but wonder – in today’s letter – what surprises the gods may have in store.
"Surprise lies at the foundation of all undertakings, [in war] without exception," wrote Carl von Clausewitz, in his tome "On War" in the early 19th century. Clausewitz, a Prussian soldier, had seen Napoleon’s army sweep through Europe. He, too, wondered who the god of war might favor, and why.
A general who catches his enemy off guard has control of the field, Clausewitz noticed. Not only does he cause confusion and discouragement in the opposing troops, he also determines the place and terms of battle – an immense advantage.
In the present war, such as it is, it was the enemy who made the surprise move. The American response, as far as we can tell, has been as predictable as a teenager’s slouch. It is not only the response the enemy expected…but the one he wanted.
Sometimes you can win by doing what the enemy intends. But few enemies are gracious enough to set traps for themselves. More often, they set traps for their opponents.
That is why it is rarely wise to attack an enemy head- on. Instead, a smart commander, Clausewitz explains, attacks at the unexpected point – on the enemy’s flanks. "By directing a force against the enemy’s flank and rear its efficacy may be much intensified," the Prussian continues.
Military history – like the history of markets – is a sad chronicle of mob-thinking inspiring people to do moronic things. Among the common stupidities is the direct attack against fortified positions. "The defensive form of war is in itself stronger than the offensive," Clausewitz believed. Military strategy should be focused not on how to attack the enemy but how to get the enemy to attack you. The enemy then exhausts himself – like the Confederate army at Gettysburg…or the French in the early days of WWI – against the defensive barriers.
This principle is especially relevant in cases of guerilla warfare. The guerilla knows he cannot beat his enemy in a pitched battle, so he hits with limited resources at carefully-selected targets – blowing up trains…shooting archdukes…or driving commercial aircraft into skyscrapers – inviting his opponent to strike back with massed force.
"The immediate object here is neither the conquest of the enemy’s territory nor the defeat of his armed force," Clausewitz observed, "but merely to do him damage in a general way." If the god of war smiles on your enterprise, the enemy is provoked to attack in force and then he is worn out by "a gradual exhaustion of the physical powers and of the will by the long continuance of exertion."
That is what happened to the Soviets in Afghanistan. Could it happen to U.S. forces too?
I don’t know. But, occasionally, the gods go over to the other side.
Your editor, American, and flaunting it…
May 20, 2002 — Paris, France
P.S. I have nothing against people killing themselves for what they believe in – especially if it is something insane. But, given my preference, I’d rather die of natural causes…and I’m not even very happy with that.
"As a measure of last week’s ‘mini-bubble’," observes Capital Insight’s Sean Corrigan, "consider that the best performing industry groups were, in order, chips, software, tech, telecoms, biotech, broadcasting and entertainment…while things we might actually need filled the losers ranks: utilities, metals, distillers, brewers and food."
Of course, by pointing out these details to you we’re joining a little group of "Doomsayers Ring[ing] Alarm Bells on Recovery," according to a NY Times headline.
With derision dripping like apple juice from the chin of 2 year-old, the NY Times sums up the same bit of research done by Morgan Stanley’s Stephen Roach that we cited over the weekend: "Consumer spending stumbles, unemployment shoots higher, stocks head for another nose-dive, dormant inflation turns into suffocating deflation. And the Federal Reserve, having already slashed short-term rates to 40-year lows of 1.75 percent to spur growth, will have little room left to cut rates anymore."
Hey, they said it…we’re just passing it on. Although we might add to the list: rising personal bankruptcies, crushing debt-loads carried by businesses, and unemployment hitting 7 1/2 year highs in April, with more on the way.
At least the stock market, rally in hand, is clearly indicating we’re heading in the right direction. Or not.
The market’s surge on Friday represented the seventh time the Dow has surged 300-points since early 2000, five of which deflated in less than two weeks. The rally also marked the 17th time the Dow has crossed the now- not-so-magical 10,000 mark since March of 1999. The last 16 of which didn’t take.
Eric, more details from the belly of the beast?
Eric Fry in New York…
– Finally, the bulls enjoyed a few days in the sun, as stocks racked up hefty gains last week. The Nasdaq led the way by surging 8.8% to 1,741 – "Its first five- session winning streak in seven months," Addison pointed out over the weekend, "and the biggest weekly gain it has been privy to in over a year."
– The Dow gained a respectable 4.2% for the week, while the S&P 500 jumped nearly 5%.
– As "markets make opinions," investors’ opinions seem to be more bullish today than they were one week ago. The very same economy that seemed – one week ago – to be sliding back into a recessionary abyss is now thought to be soaring toward recovery.
– Of course, the economy can’t be much different today than it was seven days ago. Nor is the mystery about its near-term direction any less mysterious today than it was last Monday.
– We do know, however, beyond a shadow of a doubt, that Nasdaq stocks are 8.8% more richly valued today than they were one week ago. And that’s a fact that ought to give pause to even the most optimistic of investors.
– Meanwhile, gold continues to delight its fans and to confound its critics. The precious metal keeps hanging tough, even when the stock market rallies. That’s quite a change of character for a metal with the bad habit of zigging lower whenever the stock market zags higher.
– Despite last week’s huge stock market rally, gold held its ground. And the next best thing to a market that goes up is one that refuses to go down. The gold market is becoming very interesting.
– Now, for no particular reason, we turn to the subject of derivatives. Depending upon whom you ask, these manmade financial creations are either the greatest innovation since the printing press or the certain undoing of the entire U.S. financial system.
– For our part, we are suspicious of anything that – like women’s breasts in Los Angeles – seems too good to be true. How can any financial instruments, especially highly complex ones created by Wall Street, be good for EVERYONE? And yet, this is the precise point of view volunteered by our illustrious Fed Chairman.
– As quoted in the latest issue of Grant’s Interest Rate Observer, Greenspan says, "Conceptual advances in pricing options and other complex financial products…have significantly lowered the costs and expanded the opportunities for hedging risks…These financial products have contributed importantly to the development of a far more flexible and efficient financial system – both domestically and internationally – than we had just 20 or 30 years ago."
– "As usual, Greenspan’s meaning is not entirely clear," writes Andrew Kashdan of Apogee Research. "We do know, however, that the Nasdaq collapsed in a very "flexible and efficient" manner from over 5,000 to less than 1,700. Perhaps, this is a vast improvement upon all the outdated ways of destroying capital."
– Does anyone genuinely believe that our financial system is safer and more reliable, simply because we have piled derivatives on top of one another from here to the edge of the solar system?
– Certainly, case-by-case, a given derivative can offset a given risk. A put option, for example, is a handy derivative. An investor who owns shares of IBM might wish to offset the risk of a decline by buying a put option on IBM. If the stock falls, the put buyer would have successfully protected against the risk of capital loss. But what is true in isolated cases is not at all true in the aggregate.
– For example, if I were to trade in my car for a big- rig tractor-trailer, I could drive back and forth to the supermarket less exposed to the risk of injury from a traffic accident. But in hedging away some of my personal traffic-accident risk, many other people must assume greater risk – i.e., that I run into them with my great big tractor-trailer.
– In other words, my gain may be someone else’s loss. Or as Pimco’s Bill Gross observes matter-of-factly about the derivatives known as interest rate swaps, "Swaps hold no magic really. If short rates move up, one side loses while the other side gets paid."
– Risk – like matter itself – is impossible to destroy. Derivatives merely break risk up into little pieces and spread it around. But the risk remains…somewhere. The more derivatives we create, the less we know where "somewhere" might be. Does this ignorance make our economic system safer?
– Charlie Munger, Warren Buffett’s longtime partner, offers a counterpoint to Chairman Greenspan’s rosy assessment of derivatives.
– At the recent Berkshire Hathaway annual shareholder meeting, Munger quipped, "To say derivative accounting in America is in the sewer is an insult to sewage."
– Munger does not criticize derivatives, per se, merely the way that many corporations use them to conceal material (read: unflattering) financial facts. But if corporations use derivatives to conceal material facts, and thereby to increase the balance sheet leverage, is system wide economic risk: a) greater or b) smaller? The correct answer is "a) greater."
– Tomorrow, we’ll take a look at derivatives in the gold market and what they might mean for the price of the precious metal.
Back in Paris…
*** The economist Paul Kasriel, with whom we often agree, suggests to the NY Times that there are some positive indicators in place for a recovery. Among them…the Fed appears intent on keeping rates low; government spending is on the rise; workers are logging more overtime; and capital spending is on the way up. It’s a rosy Keynesian dream scenario if we ever saw one.
*** But concerns over the stimulative effect of forever low rates on the housing bubble comes from afar… down under, in fact. "Housing prices have been very strong in our major cities," writes Ian Huntley, with whom I enjoyed a fine bottle of Tyrrels and a kangaroo barbecue on his balcony overlooking Middle Harbor in North Sydney, nary a month ago.
"With 20 per cent rises in Sydney and Melbourne, our largest cities are capping a four-year period of strength," says Huntley. "In fact, after putting up rates 0.25 per cent in early May, Royal Bank Australia (RBA) Governor Ian MacFarlane firmly pointed to the rise in house prices as one of the significant reasons for the rate rises.
"He pointed to a consensus estimate of an overall one percent hike in rates, and also went on to give an analysis of home price rises in terms of mortgage averages divided by average weekly wages, which ratio had approximately doubled over the last 20 years. He put this down in part to both husband/wife working, and it is obviously also due to interest rates collapsing over that period.
"Traditional Australian boom/busts over many decades have always ended in a housing price boom, followed by a credit squeeze and significant grief.
"Perhaps MacFarlane is the first of many Central Bank Governors to take on a housing price boom, built by rate falls aimed at stimulating the economy. The UK looks likely to be next, and presumably a bit down the track Alan Greenspan will stop dismissing ideas of a housing price bubble, and talk about irrational exuberance in this market, too…"
*** Ian recently built a database of every publicly listed company in Australia, which he’s now leasing, in part, to the ASX, the firm responsible for the Australian stock exchange. All you could ever wanted to know about Australian shares, is right here:
*** Today is Pentecost, yet another beautiful Parisian spring holiday. Bill is down at Ouzilly getting some important work done. I think he’s still building the stonewall around the garden. ("You know, Addison," he said to me last fall, "we’re using the same techniques to build this wall that they’ve been using in this part of France since the Roman occupation.")
*** In any case, Bill will be back in Paris in the morning. Until then, enjoy. The DR classique below.