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Today's Market WrapUp |
Geopolitical Risk is as Important as Financial Risk
When it comes to the financial markets, geopolitical events are a nonentity. Very few firms analyze political risk other than to monitor legislation coming out of Washington. If political risks are considered, it is usually whether a particular bill will get passed that could harm or benefit the industry. Capital gains taxes, investment tax credits, the double-taxation of dividends and investment losses are all on everyone’s radar screen. Outside direct legislation, outside events or geopolitical events that could impact our economy and financial markets aren’t followed or given any attention. The coming war in Iraq is a good example. Most stories I’ve read expect nothing but good things to follow -- lower oil prices being one of them. It is assumed, for example, that a quick U.S. victory would lead immediately to lower oil prices. The current $4-5 war premium priced into oil would quickly be removed. This would act as a stimulus to economies in the western world whose lifeblood is the flow of oil. Once Iraqi oil reserves are developed, the price of oil would head even lower.
As the graph below indicates, the rise in commodity prices and especially oil are closely associated with recessions in the U.S. The CRB Index of 17 items currently has three energy components: crude oil, natural gas, and heating oil. The price of just about every commodity has been rising this year as the current graph of the CRB illustrates. The big move this year has been in energy, grains and the metals. The prices of many of the index components have risen even more than the index itself. As shown in the graph, cocoa is up 48%. At one point in October the price was up 107%. The price of wheat, which is up 22% for the year, rose 48% from its May low to its October high. You’ll find similar price increases for other commodities as well. But let's stick with oil, because next to water, it is the most important commodity related to our health and our economy. It is outside the purview of most analysts to look at geopolitical risks in making their investment calculations. It is assumed that about 90-95% of all known factors relevant for investment consideration lie within the umbrella of the bell shaped curve. Outside, non-linear, unexpected ten-sigma events do not exist. They are considered to be so remote that their potential is considered to be nonexistent. Events such as the terrorist attacks of September 11th are considered to be a statistical anomaly, a freak occurrence unlikely to occur.
Charts courtesy of www.ino.com
I find this kind of thinking at bit odd at the moment since the U.S. is now in a state of war. It isn’t the traditional kind of war like the so many wars fought in the last century. There are no large armies gathered across the battlefield lined up to oppose each other. Iraq is the first state that the U.S. military will confront in the traditional and conventional sense, but it is unlikely Iraq will fight back with conventional means. The Gulf War showed rogue states and terrorists the futility in fighting a conventional war with the U.S., so asymmetric tactics will be used against us. Asymmetric warfare uses stealth and terror as its main weapon. It also exploits the strengths and weaknesses of the force it opposes. In a military sense it is Clausewitz versus Sun-tzu. This will be an asymmetric war. Most battles will be fought at close range, in dark corridors and hidden places that most people will never hear about. The only time this war hits home is when it strikes "home." Unlike the previous wars of the industrial age, our borders and two oceans have separated us from the rest of the world and have protected America. Today America’s borders are its greatest vulnerability.
At a time when terrorists have plans to target the energy infrastructure and when future terrorist attacks are also being planned, I find the current complacency in the markets at odds with reality. It is inconceivable to the financial markets that such events would happen again. Even when they did, as horrible as they may be with the loss of life, the American economy quickly recovered. The financial markets reopened, the stock market went on to recover, and the economy emerged out of a recession. It would take an expansion of close to $690 billion in the money supply and five-interest rate cuts bringing down interest rates from 3.5% to 1.25% to keep us from falling into the abyss. Nonetheless, the economy and the financial markets did recover. I'm sure this is the point behind much of today’s thinking. The U.S. economy is the equivalent of a large aircraft carrier. It would take a lot to slow it down or sink it, so complacency abounds everywhere.
Not all are complacent, however. The Bank for International Settlements (web link) recently set up the Financial Stability Institute to study systemic breakdowns in the financial system. The Council on Foreign Relations in New York is running simulation games on financial collapse. The individuals involved in these simulations represent a VIP list from Wall Street and Washington. Various regional Fed districts have been holding symposiums and conferences on financial collapse. Last week the Fed Chairman and the Vice Chairman of the Fed gave speeches on the potential risks of a derivative mishap. They pointed out the risks in quiet detail and then dismissed their probability of occurrence. This is called covering your own tail in the business. We warned and told you so, in case they occur. Very powerful people and institutions have been studying this matter because of the increasing frequency of their occurrence. Might I say that “regularity” of their occurrence instead of “frequency” would better describe the situation?
In regard to a ten-sigma event in the form of another terrorist attack, one may want to read three position papers on the Council On Foreign Relations web site entitled “The Threatening Storm: The Case For Invading Iraq” by Kenneth Pollack, “America—Still Unprepared, Still in Danger” Senate testimony of Stephen Flynn, original Hart-Rudman Report, and “Blood on the Doorstep” by Barnett Rubin. www.cfr.org/index.php
Today's Market
Back at the casino, stocks took a big hit today as the major indexes suffered their biggest decline since the first week of November. Concerns mount that the economy is slowing. The Consumer Conference Board’s consumer confidence index rose from 79.4 in October to 84.1. The index rose mainly due to rising stock prices. The index is a lagging indicator that has been tracking the rise and fall of the stock market. Confidence rises after the markets rally and falls when it declines. The government revised the GDP numbers for the 3rd quarter. There are many particulars that make this number worrisome, not to mention believable. The chief worry is that inventories rose to the highest level since the fourth quarter of 2000 just before the recession. There are a lot of goods that will have to be moved through the system before they are replenished again. New home sales fell by 4.5%. Retail sales and housing are key economic indicators to watch for any signs of consumer retrenchment and the deflating of the mortgage, real estate, and consumption bubbles.
The fact that the markets reacted the way they did is not extraordinary. There is nothing new here that we haven’t seen or been aware of before. Could it be that this bear market rally, which has run the typical number of days and percentage gains as previous rallies, has run its course? There has been no fundamental change from October 9th up to today. There has been no surge in earnings and the economic situation has worsened. It may be that those who hyped this rally may now be short the rally. It could also be that earnings warnings should start reappearing next month. There are a lot of questions regarding Q4. The Street has already lowered pro forma estimates to 14.9% for the quarter. I say pro forma because the real GAAP numbers, of course, will be much worse. But in this game of earnings that is played each quarter, we now deal with fiction and make believe rather than reality. Estimates should begin dropping each week as we get closer to the end of the quarter. They should then be lowered to such a low mark that companies will be able to beat them, which will become the real story. Q4 estimates have already dropped from over 17% last month and from 16.5% last week to the current estimates of 14.9%, which is still too high. Heaven knows what the real numbers will be. The pro forma numbers exclude stock option expense, pension losses, and most restructuring charges. The 14.9% are the Disneyland numbers.
As far as the markets are concerned, the major indexes, especially the NASDAQ, are pushing against strong resistance lines at the 200-day moving average and the neckline of a head and shoulders. There are also divergences in momentum, short-term MACD, and RSI.
Chip and networking stocks got pummeled today along with brokerage, biotech and other financial stocks. Tomorrow could be another volatile session with economic reports out on durable goods, personal income and spending, weekly unemployment claims, and consumer sentiment.
Volume came in at 1.5 billion on the NYSE and 1.9 billion on the NASDAQ. Breadth was decidedly negative by 20-11 on the NYSE and by 20-12 on the NASDAQ. The VIX jumped 1.79 to 28.74 and the VXN rose 2.31 to 47.99.