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War and the Markets

By Steve Saville
February, 2003

My current view is that the gold price will move considerably higher and the US$ will move considerably lower during the first half of this year (following short-lived counter-trend reactions) and that the US stock market will fall below last October's low. The Iraq situation represents the biggest threat to these views. As far as we can tell, the main objective of the Americans is to gain control of Iraq, the main objective of the Europeans is to prevent the Americans from gaining control of Iraq, and the main objective of Saddam Hussein is to stay in power. How this plays out is anyone's guess.

If uncertainty was removed, either by the US attacking Iraq or by the probability of war being substantially reduced, then the US stock market would experience a decent rally (our guess would be a gain of around 5-10%), thus prolonging the overall advance from the 10th October 2002 bottom by at least a few weeks. However, we don't think that the removal of this uncertainty, or any sort of war-related news for that matter, could ignite a new bull market. For one thing, the high valuations would still weigh on the market. For another thing, there really isn't much of a 'war discount' in the stock market. Various indicators of sentiment show that market sentiment is presently quite complacent, so it isn't the case that the market is being held back by a wall of fear and, therefore, that it is positioned to surge forward once war-related anxiety is removed.

The market in which the removal of any 'war discount' would have the biggest impact is, we think, the currency market. Almost every time the US$ has fallen over the past 2 months the financial media has blamed the brewing conflicts with Iraq and/or North Korea. Dollar weakness has absolutely nothing to do with Iraq, but unlike the stock market the US$ is extremely oversold. As such, any news that is widely perceived to be bullish could be the catalyst for a powerful US$ rebound.

Since the gold price will almost certainly continue to trend in the opposite direction to the US$, anything that causes a sharp rally in the dollar is likely to cause a sharp pullback in the gold price.

As far as the financial markets are concerned Iraq is a major distraction. If not for the seemingly-inexorable march toward an invasion of Iraq the markets would be focused on corporate earnings and the economy, in which case the probability of significant additional upside in the stock market or anything more than a 2-4 week 'dead cat bounce' in the US$ would be very low.

The US Stock Market

The current consensus is that there will be a war in Iraq and that the start of this war will be the catalyst for a substantial rally in the stock market and a substantial decline in the gold market. The 'logic' is that the current uncertainty has kept a lid on the stock market and put upward pressure on the gold price. And, when that uncertainty disappears due to the official commencement of a military campaign the lid will be removed from the stock market and the upward pressure will be removed from the gold market.

The proponents of this view use the 1991 war against Iraq to support their case. During the second half of 1990, while preparations were being made for a war against Iraq in response to Iraq's invasion of Kuwait, the US stock market was very weak and the gold price was firm. But, as soon as the US and its allies began dropping bombs on Baghdad the US stock market started a major bull run that would result in the Dow Industrials Index gaining 20% during the ensuing 2 months and 36% during the ensuing 18 months (see chart below).

There are, however, some major differences between January-1991 (when the bombs began to fall) and now.

First, sentiment was very bearish then and is quite bullish now. For example, in January of 1991 more than 50% of investment newsletter writers were bearish (as per the survey conducted by Investors' Intelligence) versus about 25% today. Actually, prior to the 1991 bottom the bearish percentage had consistently been greater than 50% for several months whereas during the past 2 years it has never moved higher than 43%.

One reason for the difference in sentiment between 'now' and 'then' is that the consensus view, prior to the start of the 1991 war, was that the military campaign would be difficult. Today the consensus view is that the campaign will be quick and easy. So if the market is already discounting the best possible outcome, where's the upside?

Second, mutual fund cash levels were 12% at the 1991 bottom versus 5% now. This indicates that mutual fund managers were bearish then and are bullish now, and means that the potential buying power at the 1991 bottom was far greater than it is now.

Third, at the 1991 bottom the Dow dividend yield was 4.2% and the S&P500 dividend yield was 3.9%. Today, the dividend yields are 2.2% for the Dow Industrials and 1.8% for the S&P500. So, by this important measure the market is twice as expensive today as it was in 1991.

Fourth, the price/earnings ratio for the S&P500 Index was 15 in January of 1991. Today it is 29. So, by this measure the market is twice as expensive now as it was then.

Fifth, in January of 1991 the S&P500 Index was selling at around 2-times book value. Today it is selling for around 4-times book value. So, by this measure the market is twice as expensive today as it was at the 1991 bottom. Are you getting the picture?

Sixth, at the 1991 bottom the US had a current account surplus. Today it has a huge current account deficit.

Seventh, the objective in 1991 was to chase Iraq out of Kuwait. However, if a war erupts this year the likely objective will be the occupation of Iraq. This objective will almost certainly take more time to achieve and will entail a much greater cost in terms of both money and lives.

In summary, in January of 1991 valuation and sentiment were conducive to the start of a bull market. Today, they are conducive to the continuation of the major bear market that began almost 3 years ago. In our opinion the market has downside risk of around 50% over the coming 6 months versus upside risk of around 15%, so the risk/reward ratio is lousy. That risk/reward ratio is not going to improve if a war breaks out, although the commencement of a war would certainly result in huge volatility and quite likely a surge in the major stock indices and plunge in the prices of gold stocks. These moves would, however, be short-lived because bear-market conditions would still be in place for the stock market and bull-market conditions would still be in place for the gold market (the bull market in gold is a result of the bear market in the US$ and this, in turn, relates to the US current account deficit and the perceived inability of dollar-denominated investments to provide substantial returns over the next few years).

Steve Saville
Hong Kong