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Pre-Battle Fatigue
Hitler punished Wall Street. So is Iraq.


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What’s worrying the stock market? War. Sure, investors are disappointed that corporate profits have not rebounded vigorously and that the economy grew just 0.7 percent in the fourth quarter of last year. But those problems, too, are linked to the imminent conflict with Iraq.

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Here’s how the Federal Reserve put it last week: 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% 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% over the next six months and 24 percent in 1951. Stocks fell 6% 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% 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%.

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%. 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%.

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%; health care, specialty retail, and housewares each rose more than 40%. 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, NRO Financial contributing editor and 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.

— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. This column originally appeared in the Washington Post.



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