Clicking on banner ads enables JWR to constantly improve
Jewish World Review Feb. 11, 2003 / 9 Adar I, 5763

James K. Glassman

Jim Glassman
JWR's Pundits
World Editorial
Cartoon Showcase

Mallard Fillmore

Michael Barone
Mona Charen
Linda Chavez
Ann Coulter
Greg Crosby
Larry Elder
Don Feder
Suzanne Fields
Paul Greenberg
Bob Greene
Betsy Hart
Nat Hentoff
David Horowitz
Marianne Jennings
Michael Kelly
Mort Kondracke
Ch. Krauthammer
Lawrence Kudlow
Dr. Laura
John Leo
David Limbaugh
Michelle Malkin
Chris Matthews
Michael Medved
MUGGER
Kathleen Parker
Wes Pruden
Sam Schulman
Amity Shlaes
Tony Snow
Thomas Sowell
Cal Thomas
Jonathan S. Tobin
Ben Wattenberg
George Will
Bruce Williams
Walter Williams
Mort Zuckerman

Consumer Reports

It's the war, stupid

http://www.NewsAndOpinion.com |
What's worrying the stock market? War. Sure, investors are disappointed that corporate profits have not rebounded vigorously and that the economy grew, as we learned, just 0.7 percent in the fourth quarter of last year. But those problems, too, are linked to the imminent conflict with Iraq.

Here's how the Federal Reserve put it Wednesday: High oil prices and "other aspects of geopolitical risks have reportedly fostered continued restraint on spending and hiring by businesses." As those risks lift, monetary policy and productivity growth "will provide support to an improving economic climate over time."

Translation: It's the war, stupid.

Some people believe war is good for an economy. It's not. War is a drain on a society's resources. For example, money goes into making bombs, which literally self-destruct, rather than into long-term investments that keep providing value - such as, say, auto plants or computers. Smart, diligent people have their brainpower and their energies diverted by war - and, oh, by the way, some get maimed or killed.

On the other hand, war can change a threatening, unsettled environment into one that is more secure and conducive to economic progress. War can be seen as a long-term investment - not just in humane values and freedom but in the economy as well.

The problem is that markets are so frightened of the uncertainty generated by an impending war that they can't see through the fog to the clearing on the other side. Ed Keon, a Prudential strategist, says, "The fear of conflict has historically been worse for stock prices than conflict itself."

Consider World War II. Between 1939 and 1941, Hitler was marching across Europe and the Japanese across Asia. For Americans, war was growing closer. Meanwhile, the economy was recovering, slowly but surely, from the Great Depression. Yet the stock market fell in each of those years (the last time it would decline in three consecutive years until 2002).

On Dec. 7, 1941, the Japanese attacked Pearl Harbor, and the U.S. entered the war. The Dow fell 9 percent over the next six months, but as the fighting went on, stocks rallied, and the period from 1942 to 1945 was the best four-year stretch in stock market history until 1995-98 broke the record.

Similarly, stocks dropped when the Korean War began in June 1950 but rose 22 percent over the next six months and 24 percent in 1951. Stocks fell 6 percent when Iraq invaded Kuwait on Aug. 2, 1990, but the benchmark Standard & Poor's 500 index surged after the war started, and it finished ahead 31 percent for 1991.

In all of these cases, the market recovered not when victory was achieved but when force was first exerted, even if initial success was minimal. Keon, in an interview with TheStreet.com, recently predicted that the stock market would "stay weak and cautious leading up to a conflict, but then move up sharply once uncertainty is gone and victory looks clear."

There are no guarantees, of course, but there is an important lesson here, and not just about war: Markets hate uncertainty. When it appears that a semblance of certainty is being restored, they respond with enthusiasm.

But don't markets deal with risk all the time? Absolutely, but risk and uncertainty aren't the same.

The critical difference between the two was first recognized by a young economist named Frank Knight, who grew up in poverty on a farm in Illinois, the oldest of 11 children, and eventually taught at the University of Chicago for 44 years. Knight wrote in 1921, "Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated."

Risk involves probability that we can know and measure. On a coin flip, for instance, we know the odds are that half the time heads will come up and half the time tails. You can get a run of 10 heads in a row, but on each new flip the odds are 50-50 that heads will appear, and over thousands of flips, heads and tails will each win about the same number of times.

When most analysts speak of stock market risk, they are talking about volatility - that is, the extremes of the market's ups and downs. This is roughly the same kind of quantifiable risk we see in coin flips. Measurements of stock volatility (such as beta or standard deviation) use history as a guide. For example, the S&P has declined in 23 of the past 77 calendar years. Thus, in any one year, your chance of losing money in a broadly diversified portfolio is about 30 percent.

This is the kind of risk most investors understand, if only intuitively. In his book "Against the Gods," a history of risk, economist Peter L. Bernstein writes, "Extrapolation of past frequencies is the favored method for arriving at judgments about what lies ahead. . . . Experienced people come to recognize that inflation is somehow associated with high interest rates . . . and that driving at high speed along city streets is dangerous."

Yes, but when we have little experience of something, we can't make such judgments. Enter uncertainty - which Knight also termed "ambiguity" or plain old "ignorance." Those terms, it seems to me, apply perfectly to a war with Iraq. Does Iraq have nuclear, chemical or biological weapons that it will release on the United States or our allies? Will Saddam blow up his oil fields, or Kuwait's and Saudi Arabia's, for that matter? Or will something utterly unimaginable happen?

(Knight believed that the unimaginable could always happen, but clearly there are times when our fears of a terrible surprise are higher than others. This is one of those times. We are conscious of our uncertainty - and act on it.)

John Maynard Keynes, who, in "The General Theory" (1937), extended Knight's ideas about risk, wrote of uncertainty: "The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest 20 years hence, or the obsolescence of a new invention. . . . About these matters, there is no scientific basis on which to form any calculable probability whatever. We simply do not know!"

Again, that's a good characterization of Iraq: We simply do not know!

I recently heard one of Washington's smartest policymakers say that the chance of something truly horrific happening in a war with Iraq is about 5 percent. Clearly, however, this number is a guess - not a true figure of probability drawn from experience (like the chances that 23 will win on a turn of the roulette wheel). It sounds right to me, but what do I know?

There are three ways to respond in the face of Knightian uncertainty. One rational reaction is to take your chips off the roulette table and walk away. That is clearly what many investors are doing. New figures, for example, show that Americans took $8 billion out of stock mutual funds in December and put an almost equal amount into bond mutual funds. Business managers, as well, are reluctant to invest.

But there's another reaction that could prove more productive. My colleague, Kevin Hassett, an economist at the American Enterprise Institute, explains this alternative in his new book, "Bubbleology": "If we have lengthy and informative experience with a particular business activity, other people probably do, too. According to Knight, we can't realize great profits from businesses that we fully understand." That notion applies as well to stocks. When everyone knows that a business is sound and the economy is wonderful and prospects are bright, stock returns will be modest.

"If Knight is correct," Hassett continues, "the kind of decisions most important to a business, and most important to the value of stocks, are made in a circumstance of extreme ignorance. . . . Sometimes, you have to fly by the seat of your pants." Or invest with your instincts.

The payoff for successful stock investing at times of high uncertainty can be enormous. Again, look at World War II. In the four years ending Dec. 31, 1945, the S&P, including dividends, rose 149 percent.

A recent study by the Dow Theory Forecasts newsletter found that sectors that had been depressed shortly before the Persian Gulf War shot up the most in 1991. Leisure and gaming stocks rose more than 60 percent; health care, specialty retail and housewares each rose more than 40 percent. Among the biggest losers were oil and gas exploration and gold and other metals - which had risen leading up to the war.

Based on this experience, the newsletter "especially likes" the prospects for selected health-care issues, including Biomet (BMET), Lincare Holdings (LNCR), Renal Care Group (RCI) and Steris (STE).

A third response to impending war with Iraq is to continue to hold what you own and, mindful that you can't divine the future, continue to invest regularly in a diversified portfolio of stocks, monthly or quarterly. This strategy recognizes both Knightian uncertainty and conventional risk. Realize that the world of investing comprises a long-term equilibrium punctuated by surprises - some pleasant, some not, but all, by definition, unpredictable. In other words, smart long-term investors know that storms can come up out of nowhere. Instead of abandoning ship in mid-ocean, they ride out the tempests and eventually get where they're going.

My assumption is that, whatever happens with Iraq, the U.S. economy will remain strong in the future. "We attribute the recent financial market weakness solely to near-term uncertainty, not a new downturn in the economy," David Malpass, the top strategist at Bear Stearns, recently wrote to his clients.

If he is correct, this could be a very good time to be investing in stocks. Just remember that the current uncertainty could intensify and prices could go lower, even much lower, and that the war, however necessary, could present nasty, costly surprises. Knight is right. Nothing is certain.

Enjoy this writer's work? Why not sign-up for the daily JWR update. It's free. Just click here.


JWR contributor James K. Glassman is the host of Tech Central Station. Comment by clicking here.

Up

02/03/03:Nothing wrong with breaking a buck
01/17/03: Dogs of the Dow
01/09/03: Eyes on the prizes
12/10/02: Time to kill, not coddle
12/02/02: Time for a drug binge?
11/13/02: The world, your oyster
10/28/02: Why stocks don't stink
10/09/02: The debt bet
09/30/02: Caution, competition ahead
09/19/02: Shopping for opportunities
08/26/02: Stop the Dumb Bond jokes
08/20/02: Moving on from 'sustainablity'
08/06/02: Put Dow doubts to rest
07/29/02: Your money for your life
07/15/02: Have your cake
07/09/02: Competition cure-all
06/26/02: Rebalancing Act
06/21/02: Technology Back on Track
06/19/02: Star Power?
06/12/02: The Beautiful Line
06/10/02: Squashing broadband
06/06/02: Frank investing advice
06/04/02: Say it ain't so, George
05/29/02: He moves in mysterious ways
05/22/02: Reel in these stocks
05/15/02: It's a "small" world
05/08/02: Goldi-stocks
05/02/02: Japanese stock growth?
04/30/02: Trust the Bells?
04/24/02: Being there is best revenge
04/18/02: I'm a Seoul man
04/16/02: Analyze this
04/09/02: The Dot.Con con game
03/21/02: The companies you keep
02/28/02: Trusting monopolists
02/22/02: How not to get taken when buying stocks
02/06/02: Investing After 9/11
01/30/02: Blue Light Specials? Advice on snapping-up K-Mart or Enron stock
01/24/02: Dare to be obscure
01/16/02: Bank on this
01/10/02: What goes down...
01/04/02: An asset-focused investor finds 'deep value' stocks
12/26/01: High-Tech Funds Low On Tech
12/19/01: Tech Sector: Blodget, Meeker, and You
12/12/01: Enron's lessons: Be skeptical of experts
12/04/01: CLECs alive and well, but not if Tauzin-Dingell passes
11/15/01: The "Next Big Thing" in Technology?
10/30/01: A National I.D. Card? Yes; Run By Larry Ellison? No
10/25/01: Without Bayer, we're bare to bioterror
10/18/01: The Battle of Biotech
10/05/01: Two Techs for Tough Times
09/26/01: The Information War
09/05/01: Tech firms built to last through tough times
08/23/01: Stocks on the A-List
08/17/01: Labor and management finding online learning to their liking
08/08/01: Game makers poised to profit
07/19/01: Trade Promotion Authority: High-Tech’s Key Component for Competitiveness
07/12/01: Nothing’s arbitrary about the contrarians
06/27/01: Look to Politics to Find Broadband's Market Cap Shortfall
06/22/01: Tech Commodity Buys Available for Mining
06/18/01: The Blackout Portfolio
06/14/01: The conservation myth stars as latest (sub)urban legend
06/07/01: Will America go high tech on the high seas?
06/05/01: 'Price gouging' doesn't cut it as reason for rising energy prices
06/01/01: Authentication tools opening up opportunities in online security
05/25/01: 'Price gouging' doesn’t cut it as reason for rising energy prices
05/21/01: Banking on High-Tech Education
05/17/01: It's No Time to Go Wobbly on Kyoto
05/02/01: Diversify with tech’s leaders
04/26/01: To Revive The New Economy, Release A Chokehold   —   Break Up The Bells
04/24/01: Who’s To Blame For Broadband Crisis? Wired Article Points To Bells
04/19/01: The Bush Budget
04/12/01: To revive The New Economy, release a chokehold --- break up the Bells
04/04/01: Even as stocks have fallen, the Net keeps booming
03/28/01: Where’s The Profit In Biotech Future?
03/22/01: The Joy of Debt: The last thing we should want is a U.S. Treasury flush with cash
03/19/01: 'Defensive' Stocks in the NASDAQ
03/15/01: Bush administration must say no to Jane and Kyoto
03/08/01: Time to buy small caps? Consider these five great techs
03/01/01: Bill’s and Larry’s continued political adventures
02/26/01: Chips on the Dips?
02/23/01: How Tauzin Can Keep His Word And Stop Telecom "Remonopolization"
02/13/01: Consumers, WAKE UP! Middlemen are ripping you off
02/02/01: Publicity-Seeking Politicians and Contingency-Fee Lawyers Corrupt the Law
01/26/01: DoubleClick, eBay And Their Promising Ilk
01/24/01: Will Cyberspace Look Like France or America?
12/27/00: Cut interest, taxes and regulation to save high-tech economy
12/20/00: Close, But No Big Czar
12/15/00: A Down Year? Maybe. But Let’s Put It in Perspective
12/13/00: Clinton’s sorry midnight race into history
12/07/00: Is Telecom’s Future The Bells, The Bells, and Only The Bells?
12/01/00: Money talks and walks in election aftermath
11/29/00: Climate Treaty Deadlock Shows Lack of Consensus and Common Sense
11/23/00: Climate change participants don’t listen to reasons for uncertainty
11/21/00: Will Regulators Create a Recession?
11/14/00: The Election and the Market
10/26/00: Hang on for the long term
10/25/00: On privacy, one size doesn’t fit all
10/24/00: Perish the bearish thought
10/19/00: Beating hunger --- the biggest prize
10/13/00: Way to play biotech
10/12/00: Bush vs. Gore on Technology
10/11/00: Global Climate Scare: Fools Rush In
10/05/00: Avoid the Apple Trap
10/03/00: Goodbye, anti-Microsoft crusader --- and good riddance
09/29/00: Should You Invest in Tech IPOs?
09/27/00: Could technology end airline delays?
09/22/00: Don’t Forget Small Caps
09/20/00: Is the New York Times Rooting for Disaster?
09/13/00: The Best Argument Against Net Regulation
08/30/00: Political Risk in Big Drug Stocks
07/27/00: Tech Dividends
07/25/00: Government Privacy Violators
07/20/00: If I Had to Pick One Tech Stock
07/18/00: Our Favorite Lawsuit
07/13/00: Silicon Valley East
07/11/00: Election 2000: Year of the Investor Class?
07/07/00: Adventures on the Amazon.com
07/06/00:The Difference Between Bill Gates and Larry Ellison
06/29/00: In the Chips
06/27/00: Free market wins in Federal Court!
06/22/00: Wireless Bargains?
06/20/00: Is Your SUV Warming the Planet?
06/15/00: Shopping for Government
06/13/00: Top 10 Tech Stocks
06/08/00: Riding the eBook Wave
06/06/00: "The Last Mile"
06/02/00: Keep Buying!
05/31/00: Who Asked the FTC to Regulate Online Privacy?
05/25/00: "When It’s Time to Sell"
05/23/00: End the "Telephone Tax"
05/16/00: Time Warner Gets a Bad Rap

© 2002, Tech Central Station