Category: war

War complacency

With investor complacency already high (65% of the sub-10 VIX readings since 1993 took place in the past 3 months), it should be no surprise that the escalation of tensions with North Korea would be met with a yawn.

At 2:21 PM E.T. yesterday (with the S&P 500 down 0.87% on its way to a 1.45% loss), MarketWatch columnist Mark Hulbert published an article advising investors to remain calm:

If war breaks out with North Korea, we’ll have bigger things to worry about than our portfolios.  But that’s OK, because doing nothing is almost always the best investment strategy during a geopolitical crisis.

That is the clear conclusion to emerge from an analysis conducted by Ned Davis Research of the most momentous geopolitical crises of the last century. The firm found that far more often than not, the stock market, as measured by the Dow Jones Industrial Average strongly rebounds from its post-crisis panic low — so much so that within six months it is actually higher than where it stood before that crisis erupted.

The research report covered 51 events from 1900 to 2014, including the bombing of Pearl Harbor and JFK assassination.  Of note: the average stock market drop during each crisis was 17.5%, so the positive returns came after a fair amount of pain.  With stock valuations broadly at record high valuations, it is not difficult to envision a much larger correction if war breaks out with North Korea.

One problem with these sorts of back tests is that economic and market events can’t be replicated in a lab.  History doesn’t repeat, though it often rhymes.  To unravel this complicated puzzle, let’s look at three variables: valuations, sentiment and economics.  From a valuation standpoint, there is no way to compare past crisis lows to today’s twin asset bubbles in both stocks and bonds (at the lowest yields in 5,000 years of recorded history).

As for sentiment, a bit of history:

  • After WWI there was a sharp but brief depression in 1921.
  • After WWII, economists predicted another depression.  Instead we got a two-decades-long boom.
  • Initially, in the early-1960s there was complacency about the Vietnam conflict.  That eventually ushered in the intractable inflation of the ‘70s, which helped trigger (along with Watergate) the worst bear market in stocks since 1929-32, in real terms, from 1972-74.
  • The Gulf War brought back memories of the quagmire in Vietnam and was widely anticipated.  Stocks sold off in late 1990 as a result.  Operation Desert Storm began mid-January of 1991 and was over in a month.  There was no quagmire.
  • In 2003, the Iraq War was widely predicted to be brief, but it turned into quagmire.  Fortunately for stocks, they were 3 years into a burst tech bubble and prepared for bad news.  An aggressive Fed fomented the housing/credit bubble of the mid-2000s.

The lesson of #4 and #5 was that war – brief or quagmire – leads to bull markets.  Investors constantly fight the last war.  The complacency regarding North Korea is a direct reflection of recent past war experience plus an 8-year bull market where buy-the-dip behavior has been constantly reinforced by central bank asset purchases.

Lastly, let’s take a look at economics.  With the onset of war, we can expect the following to occur:

  1. The war economy is engorged while the real economy (or consumer economy) is drained.  GDP growth is highly misleading during wartime.  The consumer is worse off as resources are siphoned off to be destroyed (see chapter 3 of Henry Hazlitt’s Economics in One Lesson, “The Blessings of Destruction“).
  2. The immense costs of war are paid for through government borrowing and inflation.
  3. Government, aka the public sector parasite, is ratcheted up during war, but doesn’t relinquish all of those gains after the war (see Crisis and Leviathan by Robert Higgs).

Imagine these maladies foisted on an economy struggling to grow (the most anemic recovery post-WWII) and wheezing under record debt levels including $20 trillion of government debt (having doubled the past 8 years), $1.2 trillion in auto loan debt, $539 billion in margin debt, etc.  That debt has remained manageable thanks to miniscule interest rates, but a wartime economy would threaten this state of nirvana.

Moral of the story: act before the crisis.  With stocks and bonds priced for perfection, ignore impending danger at your peril.

William Ebenstein on dictators

History is a vast graveyard filled with “realists” like Napoleon, William II, Hitler, and Mussolini. They all underestimated the important imponderables in the equation of power but missed, in particular, the one component that in the end proved decisive: The will of man to be free, to put freedom above all other goods, even above life itself. — William Ebenstein

Hans Sennholz on war and peace

Peace is the natural state of man, war the temporary repeal of reason and virtue. — Hans F. Sennholz

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