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Why an invasion won't save the market
The smart money is betting on a war rally -- just not a sustained one. Here's why getting into the market when it feels wrong will put you in the right place for the uptick.
By Jon D. Markman
If everybody knows that the United States plans to invade Iraq within the next 30 days, and everybody knows that stocks will explode higher when the cruise missiles launch, then why the heck hasnt the market stabilized already as smart money floods in to anticipate the inevitable?
The answer appears to be twofold: Under-the-radar buying by the smart money is keeping the market from declining farther, faster. But the smart money isnt purchasing with abandon because it doesnt buy the consensus view that the start of war will kick off a sustained bull market.
The view among veteran investors who have played the bear market correctly so far is that an American invasion of Iraq will end the uncertainty over when and whether hostilities will begin, kicking off a relief rally in equities likely to last one to six weeks. But they believe that this speculative advance is unlikely to spell the end of the millennial bear market, and it should ultimately be considered an opportunity to unload stocks rather than to load up.
Said Mr. P, a 30-year macro hedge fund manager who has anonymously contributed insights to SuperModels for the past three years: Our view is that youve got to be buying now, a little every day as the market goes down, to play for the reversal. And that 75% of your returns for this year will come between the start of the war rally and May.
In other words, youve got to be willing to withstand some pain by losing now to be in position to make money when the market reverses course. But you also have to be ready to change directions and sell before the rally runs out of steam in late spring. The advance will end quickly, make no mistake, the fund manager says.
What you really stand to gain
The idea of most of 2003 returns becoming available in a highly charged period of less than six weeks should grab your attention. Lets see how it could potentially play out.
There have been four significant bear-market rallies since the major market averages topped out in 2000.- March to May 2001: The S&P 500 ($INX) went from 1,122 to 1,312. A 17% move.
- September 2001 to January 2002: The S&P 500 went from 984 to 1,164, an 18% move.
- July 2002 to August 2002: The S&P 500 went from 796 to 962, a 21% move.
- October 2002 to December 2002: The S&P 500 went from 775 to 941, a 21% move.
In each case, as you can see, the bear-market rallies lasted no longer than four months and generated no more than a 21% gain. In most cases, the greatest part of the gains came in the first few days and weeks, catching most investors flatfooted and too unsure of themselves to participate. Since hardly anyone reverses from all cash to a fully invested position at the moment of the upward reversal and then cashes out again at the exact moment of the downward reversal, its fair to say that even fleet-footed investors probably caught no more than half to two-thirds of these moves, yielding gains of around 10% to 12%.
With that in mind, consider some scenarios for capturing the next reversal. We need to make some assumptions first.- Lets say that at the beginning of the year, you believed that it was likely that the broad market would advance 7%. Not much by 1990s standards, but in line with the S&P 500s annual return since the 1950s, not including dividends.
- Now lets say that the Iraq invasion doesnt begin until the market sinks to its October 2002 low.
- And finally, lets say that the rally equals the force of the four previous bear-market advances.
The S&P 500 started 2003 at 880. A 7% advance would take it to 941.76. The S&P bottomed in October 2002 at around 776. If you do the math, youll see that a move from 776 to 941 would be exactly 21.3%, which youll recall is the maximum gain achieved in the past rallies.
So to achieve your modest 7% objective for the year, youve got to capture a whopping 21% move from the hypothetical pre-invasion pessimism low to the hypothetical post-invasion euphoria high. And the only way to do that is to have your portfolio fully invested at the lows -- a time when its going to seem smart to be doing anything but owning stocks.
That sounds pretty hard. Especially since the biggest assumption of all is that the war starts well and progresses smoothly, and that the U.S. action is perceived as a wondrous success by investors internationally, as well as at home.
Holes in the case for a sustained rally
The view that this could, in fact, transpire is drawn from a meager set of recent experiences, the Gulf War of 1991 and the Afghanistan campaign of 2001. Yet both are poor precedents, says Paul Desmond, editor and publisher at Lowrys Reports, which many institutional investors consider the premier arbiter of market price and volume history.
In the first case, the market had begun a classic cyclical bull market rally in October 1990 in the wake of a fearsome set of six days in which 90% of New York Stock Exchange stocks had declined, creating truly bargain-basement prices. The rally that is associated with the Gulf War, Desmond says, was actually only a showy continuation of a cyclical bull market that had quietly started months before. Additionally, most of the world was united in a coalition against Iraq so the victory resonated with investors from Arkansas to Zaire.
In the second case, the market advanced rapidly in mid-October 2001 when the air campaign began in Afghanistan as the investor class worldwide generally approved of the U.S. mission to rout the Taliban backers of al-Qaida. The terrorists assault on New York and the Pentagon was seen as a provocative affront to civilized society, and a military response was considered righteous and reasonable.
An action in Iraq now meets a different set of circumstances.
On the technical side of the ledger, says Desmond, none of the conditions for a cyclical bull market are currently in place. There has not even been one panicky day in which 90% of stocks and prices in the New York Stock Exchange declined, though Jan. 27 came close, so prices are not low enough to engender widespread buying interest. Since buying interest, according to his measure, has recently hit a six-year low and selling interest has risen sharply after a modest lull in January, he believes that conditions are actually more in sync for a significant decline in prices after a brief war-related surge rather than a sustained advance.
And on the geopolitical side of the ledger, the worlds investor class is anything but united with America on the merits of battle. If the United States wins and kills a lot of Iraqi civilians in the process, the Bush administration will be considered wanton bullies -- not liberators. A steep drop in the price of oil will be a boon to the world economy and precipitate higher stock prices. But the long, tense follow-up occupation will be fraught with the potential for gnawing anxiousness and danger. And if significant numbers of Americans get hurt, whether from conventional warfare, chemical attack on soldiers or terrorist assault on civilians, then its lights out on the potential rally.
Ways to play the 'least likely' scenario
Of course, things could go great. A smooth assault in Iraq followed by the capture, abdication or death of Saddam Hussein, and an uneventful hand-off to United Nations peacekeeping forces would leave the Bush administration in the catbird seat for a triumphant return to focus on the U.S. economy and the 2004 election campaign. Jason Trennert, an analyst at ISI Group in New York, said he believes that success in Iraq would give Bush a free hand in getting his tax package through Congress, as Democrats would have a hard time blocking a popular war hero. Investors would welcome a solid one-two punch on the international and domestic fronts, as it would bring stability and certainty. With the axis of weasel -- Germany and France marginalized, attention would be paid to the emerging view that the U.S. consumer is far from dead, as tax cuts and lower interest rates do their part to gun demand.
Unfortunately, I am afraid that the good-news scenario is the least likely. Phil Erlanger, an independent researcher whos expert on investor sentiment, said he believes a Hooray, we beat the crap out of them, lets celebrate rally would launch nothing more than a short series of one-day wonders. And that anything less than the best of outcomes represents grave risk to stock prices.
No matter what happens in Iraq, he said, we are faced with a market that is slowly bleeding to death. We dont have a major capitulation event yet, and we may never have one. A bear market is water torture; its a big, grinding bore. You get days and days of churning up and down as the market works hard at going nowhere -- spiked by all sorts of seemingly important but ultimately trivial geopolitical and economic events -- until it ultimately collapses under its own weight. There is virtually nothing that military action in Iraq can do to change this. The decline will continue until people stop betting on it to stop. And that still feels like a long way off.
If you have a gambling streak and wish to play a war rally as a speculative event, rather than a major reversal event, then consider my old standby: Take positions in the lowest-priced, cheapest, worst-performing, most heavily shorted stocks in the S&P 500 Index. If the market goes up 20%, these will probably go up 50% or more as fund managers and others equitize their cash by buying the index. Stocks with the lowest prices generally advance the most in these circumstances. Through Feb. 10, the top 10 fitting the criteria are listed in the table below.
If this is too speculative for your blood, then consider scaling into the electronically traded fund representing the value of half of the S&P 500, formally known as iShares S&P 500/BARRA Value (IVE, news, msgs). It rose as much as 26% following the recent Oct. 10 low, while the S&P 500 only rose 20% and the iShares S&P 500/BARRA Growth (IVW, news, msgs) advanced just 15%.
| War rally soldiers? | | Company (Symbol) | 2/10 price | Short ratio | % Chg 1 Yr | Price/sales | | Mirant (MIR, news, msgs) | $1.62 | 5 | -83.7 | 0.03 | | Lucent Technologies (LU, news, msgs) | $1.64 | 8 | -72.8 | 0.55 | | Avaya (AV, news, msgs) | $2.22 | 12 | -65.1 | 0.16 | | Gateway (GTW, news, msgs) | $2.30 | 9 | -58.5 | 0.18 | | Calpine (CPN, news, msgs) | $2.84 | 14 | -66.2 | 0.14 | | Williams (WMB, news, msgs) | $2.92 | 5 | -80.6 | 0.17 | | AES Corp. (AES, news, msgs) | $2.99 | 10 | -70.1 | 0.18 | | AMR Corp. (AMR, news, msgs) | $3.00 | 6 | -87.3 | 0.03 | | Solectron (SLR, news, msgs) | $3.36 | 7 | -64.7 | 0.23 | | HealthSouth (HRC, news, msgs) | $3.55 | 4 | -68.4 | 0.31 |
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Fine Print
My new book, Swing Trading: Power strategies to cut risk and boost profits, is due to hit bookstores at the end of the month. It features long, detailed interviews with traders and researchers familiar to SuperModels readers, including Terry Bedford, Richard Rhodes, Phil Erlanger and George Fontanills. You can pre-order the book at Amazon.com by clicking here. Weird coincidence? The winter market rally ended on the same day I published my column titled The physics of financial catastrophe. In the interview, French scientist Didier Sornette predicted that the market would soon reverse course and stay down into 2004. The Defense Department and the wi-fi industry reached an accord late last month on the use of spectrum in the 5 GHz range. Read about it here. More news about the agreement is expected soon.
Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at supermodels@jonmark.com. He neither owned nor was short any securities mentioned in this column at the time of publication, but positions can change at any time.
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