Q1 ’03:   Gambling, Hubris and the Wages of War

Since there is a great deal of political commentary in this letter, I would like to remind my readers that the purpose of the Risk & Opportunity newsletter is to consider systemic and structural issues, including social and political as well as economic issues from the perspective of their impact on markets and investments. It is my opinion that much of the risk in the marketplace is being politically driven at this time.

That said, the purpose of this letter is to take a fresh look at the universe of market risk in the shadow of war, to review prospects for various investment categories and to suggest some strategies for the intermediate term.


This has been an especially difficult letter to write due to the turmoil and emotion surrounding the impending war. On the one hand, looking at the charts, the market is weak but it wants to rally. We are certainly due. And there are some fundamental reasons to think that we should get a rally. Foremost is the enormous stimulus of the last two years that has not yet borne fruit. On the other hand there are some very big negatives, including the fact that the enormous stimulus has not borne fruit. Fed Chairman Alan Greenspan, in his recent testimony to Congress, repeatedly emphasized his opinion that the major drag on the economy is coming from geopolitical concerns, and that he expects things to improve as soon as the situation in Iraq is resolved.

The obvious big issues weighing on the market are the war, potential terrorism and the anemic performance of the economy. The media are pounding away on these themes. But behind these obvious concerns I believe there is a growing sense of alarm over the high-risk behavior of the Bush administration. The persistent belligerent rhetoric and aggression on all fronts, domestic and international, is creating widespread anxiety over the stability of the world order, the economy and even over the constitutional foundations of our society. The markets hate uncertainty, especially when it relates to such fundamentals.

President Bush is dominating the political landscape and it has become quite clear that our President is a gambling man, and he’s no ordinary gambler; he’s a high roller. In the words of Business Week’s editorial staff, 2/17 edition, “President George W. Bush is throwing the dice in a flurry of audacious economic plans that promise to greatly stimulate American growth – or bust the budget and the economy with it.” The Economist takes a similar stand in its 2/1 review of the State of the Union address, “Caution to the Winds.” The article’s lead states “The President’s address shows him to be a risk-taker on a grand scale.”

On the international scene aggressive U.S. action is causing alarm in enemies and allies alike, and catalyzing a global realignment that could end up leaving us the odd man out. Who would have imagined that Russia, China, France and Germany would stand shoulder to shoulder against the U.S. on any issue? Yet this is case on Iraq and it is entirely our doing. France, Russia and China in particular, sensing opportunity, are positioning to displace American hegemony in Europe, the Asia and the Far East respectively should we stumble.

The biggest risk embodied in this administration, however, may not be in any one crisis that it is managing (or creating), but in the aggregate. A recent survey of White House staffers from past administrations from both parties found unanimous concern that the Bush administration is trying to do too much at once. There was general agreement that any administration can manage well only one crisis at a time. This administration is trying to enforce its will on the whole world at once. Despite broad-based opposition it is pressing its agenda on Iraq, trying to contain Korea, Israel/Palestine, Afghanistan and India/Pakistan, manage the global war on terrorism and the sick economy; plus it is trying to ram an array of controversial domestic policies and right wing judges through Congress, all at the same time. With so many balls in the air at once, the concern is that one of these balls is likely to fall, and once one falls the whole lot of them could come down. Given the high stakes the consequences could be catastrophic.

Hubris is defined as “exaggerated pride or self-confidence often resulting in retribution.” Those affected by it are convinced that they can do no wrong. Critics are dismissed out of hand. Risk is ignored, no matter how great. Negative consequences are denied. Sound familiar? “Hubris is not corrected by 20%.” Hubris is corrected by disaster. The movie “Ran” is instructive.

The War

The atmosphere around this war is much heavier than Desert Storm, Yugoslavia or Afghanistan. The world is becoming deeply polarized over this war and regardless of the immediate outcome that polarization is not a welcome development. Polls consistently show that the majority of Americans are opposed to unilateral action in Iraq, and despite a fair showing of foreign government support, the people of the world are overwhelmingly opposed to this war. Anti-Americanism is rising steadily around the world.

The U.N. could well become history over this war, and even NATO is being sorely stressed. We are alienating our allies at a time when they are desperately needed for the very real “war on terrorism.” In my efforts to understand how America is seen abroad I came across a remarkable piece of journalism in the 2/16 New York Times, “Looking at the Enemy as a Liberator,” by John Burns, in which he discovers that Iraqi refugees desperately want Saddam dead and are enthusiastic for the war, but at the same time they see the U.S. as a “greedy, menacing imperial power.” Also, a recent poll in England, our strongest ally, found that the British feel the most dangerous country in the world is not Iraq or Korea, but the United States. Food for thought.

Our relations with the rest of the world do not exist in isolation from commerce and investment opportunity. Trade relations are built on, and create, shared interests and trust. If we manage to make the whole world mistrust us, even our strongest allies, then our trade relations will suffer. The administration counters that being seen as a bully is the price of leadership. This is an unfortunate and short-sighted attitude.

If things go well in Iraq the administration will be vindicated and much of the damage done to relationships will be temporarily repaired, especially if we can demonstrate hard proof of nasty WMD enterprises in Iraq. However, given the administration’s determination to punish “evildoers,” both domestically (John Ashcroft recently ordered U.S. Attorneys to seek more death penalties) and globally, it is hard to see the end of militarism and war, and the resultant strain on international relations. We currently have Special Forces in 35 countries. And those are just the ones we know about.

There is little doubt about the final outcome of the war, but at what price? We could get lucky and be greeted at the gates of Baghdad by Saddam’s generals carrying his head. On the other hand, if they hunker down for a bloody street by street, house by house battle, will we pound Baghdad into rubble? If Saddam gasses our troops will we use nukes? There has been a lot of loose talk in Washington about using tactical nukes and the administration refuses to rule out that possibility. I can’t think of any one act that would be more destabilizing to world peace or more damaging to the world economy. (See Nicholas Kristof’s 2/14 column “Flirting With Disaster.”)

And regardless of any past enmity between Saddam and Muslim terrorist groups such as Al Queda, the insistence on war by the U.S. gives them both reason to overlook their hatred for each other and work together. (The enemy of my enemy is my friend.) This could give the terrorists of the world a big boost in resources and capability.

There are a few ways in which this war and its aftermath can go smoothly and many ways that it can go badly. There is little doubt that the Bush folk have good intentions and have a vision of a vastly improved situation in the Middle East as a result of this war, but there is clearly a large element of denial about possible negative outcomes. Good intentions notwithstanding, I find the thought regularly floating through my mind that the road to hell is paved with good intentions.

Also, let’s think for a moment about how we are paying for all of this. This military action and subsequent occupation will cost hundreds of billions of dollars that are not accounted for in already dismal budget projections. Unlike Desert Storm we are on our own on this one.

Economic Crosscurrents

War, record fiscal stimulus, deflation, low-low interest rates, overvalued stocks, earnings growth, job losses, housing strength, stratospheric oil prices. Are you dizzy yet?

I have been reading the economic numbers. For the most part they are pointing to recovery and a positive stock market. Record stimulus over the past two years is providing plenty of fuel for growth. Rates are low and will remain low. A falling dollar is improving exports and pricing power. Corporate profits are turning around. (Let’s not talk about AOL.) The consumer is still hanging in there. Housing is still strong. Job and unemployment numbers appear to be improving somewhat. The biggies on the negative side are deflationary pressures, oil prices and global instability. Assuming the latter concern eases soon, the consensus is that we will soon see a surge in economic activity.

Regardless of the numbers, however, the job situation is pretty grim. Recently, Chicago experienced a scene right out of the depression. An area of town became gridlocked one morning for no apparent reason. It turned out a rumor was circulating that a large corporation was interviewing for jobs at a local community college and thousands converged on the location. The rumor was false.

Also on the job front, due to the relentless ongoing impact of globalization, white collar jobs are now following manufacturing jobs overseas. So even if we do get something of a real recovery, future job prospects are not looking so great unless you are interested in the military. (See Business Week’s 2/3 edition “Is Your Job Next?”) I have a simple question to ask the economists. How can you have a recovery without jobs?

Economic Policy???

America long ago jettisoned fiscal prudence as a guiding principal. For the most part it is no longer even talked about seriously among policymakers. Happy talk and fraudulent projections seem to pass for fiscal responsibility these days and the debate is all about whether we should be using fiscal or monetary stimulus. A few scattered diehards have expressed alarm about the skyrocketing deficit and the irresponsibility of enacting tax cuts at the same time we are opening the spigots for war. (Does anyone remember Lyndon Johnson?) But they are all on the happy juice in Washington and they are gambling that growth from the record stimulus will inflate away the deficit — in a controlled fashion of course. (Let’s not talk about the destruction of values and the devastating consequences to our growing legions on fixed income.) If recent history is any guide, President Bush will get his way and we will be in for lots of fiscal stimulus and big deficits.

If you want to gain an understanding of what the Bush fiscal proposals really mean over the long term, I strongly recommend Paul Krugman’s 2/14 open letter to Alan Greenspan, “On the Second Day, Atlas Waffled.” The operative phrase in this piece is “…past the point of no return.” Also, for an excellent review on why the Administration’s economic plan is not going to get the desired results in the short term either, read “An Economic Plan That Cancels Itself” by Maya MacGuineas. Also, see Business Week’s 2/17 edition , “The Growth Gamble.”

But there is even more (or should I say less) to the Bush economic plan than that. In one of the more stunning and discouraging political developments of my lifetime, conservative House Republicans, who have long been the stalwarts of fiscal responsibility, have adopted a strategy of pushing up the deficit as a way to limit government spending. Sound insane? Probably because it is. (See David Firestone’s 2/11 column, “Conservatives Now See Deficits as a Tool to Fight Spending.”) This is a “scorched earth” policy for which we are all going to pay dearly. If this kind of thinking carries the day, I predict that we will very soon see trillion dollar declared deficits. If that happens the dollar will collapse, which will cause wholesale dumping of dollar denominated assets including treasuries, which will cause a huge run-up in rates, which will cause an economic collapse and all that goes with it. The consequences of decades of fiscal irresponsibility are getting ready to come home and roost.

Fortunately Greenspan threw some cold water on the “deficits don’t matter” crowd by insisting that deficits do matter, but it looks like his job may be on the line for his intransigence. We will likely soon have a new Fed chairman who is more malleable.


We remain in a primary bear market, and will be in one for years to come. Therefore, the number one investment concern should be preservation of capital. However, there are significant rallies in bear markets and from the looks of things there is a strong probability that we will see a rally once the Iraq situation is resolved. There is a mountain of cash with no place to go and a general consensus that the commencement of hostilities or shortly thereafter will be a good time to buy. If this opportunity materializes, it should be seen as a trading turn, not a long term hold. Participants should identify their profit targets and be disciplined about taking profits. Also, considering the high level of geopolitical risk, any commitments to stocks should be hedged.

Bonds are not advised right now. In fact they might be a very good short. Muni bonds in particular are a very high risk item. Municipalities across the country are having big budget problems. There will soon be a flood of offerings, increasing defaults and steadily rising rates. Real estate is also about as highly valued as it can get in this cycle. I hear from my real estate friends that it’s a great market, if you can find any deals. They’re not finding any. Gold, which has been an excellent hedge in this depressed market is currently overbought and in need of a correction. Ditto the Euro. Gold and the Euro should be considered for purchase on corrections.

In my opinion the investment strategy that holds the greatest promise for the next 10 years or so is a general category of managed investment called “absolute return strategies.” These are strategies that are deployed in many different asset categories and are designed to generate returns in all market conditions. For the most part these are hedge fund strategies that are not available to average investors. But there are some new products being developed for the general public that offer many of the advantages of absolute return strategies, such as PIMCO’s new All Asset Fund. Qualified investors who would like more detail on available opportunities should contact Cuddehe Capital Management. Contact info is on the Risk & Opportunity website.


Entropy is increasing. The aggressive behavior of the Bush administration is creating anxiety domestically and turmoil internationally, and with the presidential campaign season gearing up soon, we can expect that turmoil to start manifesting domestically as well. This is not an environment that will foster a booming economy or a bull market in anything other than perhaps gold.

The general feeling in the marketplace is heavy. Despite all the analytical talk that goes on about markets, they are really all about emotion. People buy because they are optimistic and sell (or refrain from buying) because they are pessimistic or fearful. All the analytical stuff is what people use to justify their feelings. The economists are all noting the improving numbers and looking (hopefully) for an upturn in the market once the Iraq situation is stabilized, and considering that there is a mountain of cash out there not earning anything there is a good prospect of a rally. This, however, will not be a rally to buy and hold.

I still expect the “presidential cycle” to take hold and that markets will be generally sideways to higher over the next two years as the forces of deflation and efforts to stimulate battle it out. The economy may strengthen somewhat and earnings improve due to the huge stimulus that has been pumped in and likely more on the way, and the falling dollar, but the good jobs are going to be hard to find because they are going overseas. All of this is assuming that things in Iraq go reasonably well; that global terrorism doesn’t spiral out of control; no nukes, no dirty bombs; that Korea can be pacified; that India and Pakistan don’t get into it; that Israel and Palestine don’t blow up; that there are no mysterious epidemics. In other words, there is a lot of geopolitical risk. If the world doesn’t explode into an orgy of violence, we should be able to stabilize until the next election.