Small Steps Out of the Crisis

Baldwin Louie — Tue, 25 Sep 2001 15:00:00 -0700

OPINION At last. A rally. We can breathe a big sigh of relief and gratitude simply because stocks stopped going down. And we can take delight and encouragement in the fact that yesterday's rally didn't get slammed by sellers and shorts after the first 30 minutes.

But the reality is that yesterday all the stock indices did was regain Friday's losses, and reclaim about half the ground lost on Thursday. That's nothing more than a small down payment on recovering the huge losses of one of the worst weeks in Wall Street history.

So we're not out of the woods by a long shot. But the worst of the panic is over. So now news-flow is everything. Here's a framework for evaluating the business, political and military/diplomatic news that will be inundating the super-critical markets over the coming weeks.

The most important principle is that the market will react well to anything that promises increased stability.

* Uncertainty of future earnings in a war-on-terrorism world means higher risk, and higher risk means lower stock prices.
* On top of that, investors are gripped by fear. Who can imagine what hardships we'll have to bear in a war on terrorism, and who knows when the terrorists might strike again? So the normal discount to equity prices that comes from greater perceived risk is made even greater. That means even lower stock prices.

The worst single source of potential instability is a hasty military response that could trigger unintended consequences. It's not hard to think of all the things that could go wrong.

* Hostile involvement by sub-super-powers such as China or Russia.
* Use of nuclear weapons by Central Asian sub-sub-super-powers such as Pakistan, India or Israel.
* Shutting off of Middle East oil shipments to the U.S., Europe and Japan, either by an Arab states boycott or destruction of production or shipping.
* Defection by traditional allies such as Germany or France that could trigger a trade war.
* . . . and of course, more terrorist attacks.

Just think how high the stakes are here - that's where the fear and uncertainty comes from. It's absolutely critical that the Bush administration take it slow, and think through every step. The mature and self-effacing diplomacy of a Colin Powell is just what we need - not the arrogant post-male-menopausal bloodlust of the editorial page of the Wall Street Journal.

So look for news that our military response is only one part guns to a hundred parts talk. It's no coincidence that the market rallied yesterday after it was revealed that the Bush administration intended to call the Taliban's bluff by providing convincing evidence of Osama Bin Laden's culpability - rather than bulling ahead with a massive mission of vengeance against a man not even demonstrated to be guilty.

The other big news before the market opened yesterday that jet-propelled the rally was that Taliban leader Mulla Mohammed Omar finally put a demand on the negotiating table: "If Americans want to eliminate terrorism, then they should withdraw their forces from the Gulf and they should put an end to the biased attitude on the issue of Palestine.'' I'm not trying to defend or justify the Taliban here - I realize that Omar's statement is tantamount to a particularly sleazy form of blackmail: "We didn't do it, but if you don't want us to do it again here's how much you have to pay." But nevertheless, now we know what they want, and why they did what they did.

Sure, you'll say it was obvious all along. But ever since the September 11 attack, the Bush administration has been studiously avoiding admitting the obvious - the official reasons for the "cowardly" attack were such inanities as "because we are strong" or "because we are free." Now the real issue is on the table. It's a difficult issue, to be sure, but now at least we can begin to deal with it.

Goethe said: "There is nothing so terrible as ignorance in action." With these developments, our actions - and there will be and should be actions - will be motivated and justified by knowledge. And that's movement in the direction of stability.

Military and diplomatic news-flow is the most important, but it's not the only factor - there's economic policy news, too. The stock market reacted well yesterday to the return of some semblance of order in the fixed income markets, after a week of utter chaos in which the Federal Reserve temporarily abandoned interest-rate targeting and instead determined its open market operations by, well, I really don't know by what - and no one else does either. That's why long-term bonds have lost more than 5% of their value since last week, and why gold has held onto most of its gains since September 11.

So Alan Greenspan has built a little bit of inflation into the system. Getting there the way he did wasn't a good thing from the standpoint of this analysis of stability - but I've been complaining about deflation for so long that I have to say I'm glad to see it. Now let's see if we can hold onto it, without Greenspan slamming on the deflationary brakes and taking it all back.

In the realm of other economic policy news-flow - especially in the areas of government spending and tax policy - we've actually suffered from too much stability. Immediately after the terrorist attacks I had hoped that our leadership would be galvanized out of its partisan bunkers by the need to unify around economic recovery. But so far all the pols have just dug in deeper than ever. The chances of any pro-growth supply-side incentive policies look as bleak as ever. Well, at least we'll have more pork.

The final news-flow factor determining the sense of stability will be corporate earnings announcements - and I think these are going to be bad. I don't just mean that there will be lots of warnings, like AOL Time Warner's warning last night. I mean that there will be wave after wave of warnings, and pretty soon the old tech-stock mantra "we have no visibility" will become common for all stocks. The cumulative weight of hundred and hundreds of "no guidance" announcements from Old Economy companies - whose sole virtue was their predictability - will be devastating.

So as the news flows out it will be a tug-of-war between the forces of stability and the forces of instability. And it's in the nature of that game that instability wins all ties.

So just as it was in World War II and in the Gulf War, the bottom won't come until we can see a clear way out - until the dimensions of the problem and our response are both well understood. Until that happens, sell rallies.

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Small Steps Out of the Crisis