Six Weeks in 2008 and the Forging of the Present

In the span of 40 days, the post-Cold War optimism was crushed.

By George Friedman


A little over 10 years ago, on Aug. 7, 2008, the Russo-Georgian war broke out. Six weeks later, on Sept. 15, Lehman Brothers declared bankruptcy. Though unconnected, these events marked the end of the post-Cold War world and set in motion the world we live in today.

Conflict is always most unthinkable right after a major conflict has ended. This happened with the Congress of Vienna after the Napoleonic Wars, where the victors thought they would re-establish the world that the French Revolution disrupted. There was Versailles and Trianon after World War I, when the victors thought they could reshape Europe as they wished. There was the period after World War II, when it seemed the United Nations might create an international system that would never again see war.

Some of the illusions died quickly, while others lingered. But all of them were based on the idea that the coalition that had won the war would remain intact during the peace and would manage the continent or the world, banishing conflict and laying the foundation for prosperity. It is understandable that those who fought together for so long would wish not to go to war again and to focus on prosperity. With their enemies prostrate, it seemed possible. Of course, the coalition of Vienna splintered over time, Versailles set the stage for the rebirth of Germany, and the United Nations meeting in San Francisco was merely the prelude to the Cold War.

The illusion inevitably returned in 1991 when the Soviet Union collapsed. Liberal democracy had won and would rule the world. The prosperity of the alliance structure, based on the interdependence of economies, would no longer be confined to the anti-Soviet alliance but would become a permanent feature of the world. Nationalism would be abolished in favor of multinational institutions that would maintain the peace and prosperity of the world. At the Davos meetings, people agreed that the primary interest of the world was economic; that war, save for the actions of rogue states, was obsolete; and that the interests of the world would be managed by the political, economic and intellectual elites, as an exercise in cooperative problem-solving. There were wars – Bosnia, Kosovo, Iraq – and certainly 9/11 raised serious questions about the viability of this notion. But the illusion lived on – that the alliance would deal with the Balkans, would deal with Iraq, and would deal with al-Qaida and the jihadist movement.

Reality pierced the illusion when Russia invaded Georgia. As with all wars, its origins are shrouded in uncertainty and controversy. What cannot be debated is that it was the moment that Russia returned to history as a power that was prepared to use force to defend what it saw as its interests. This violated the orthodoxies of the post-Cold War world. Russia was seen as a shattered nation, lacking the will and the ability to wage even a small war. It was supposed to be a liberal democracy, however imperfect, with its primary interest being economic. It made no sense to fight a war with Georgia or anyone else.

But Russia did not see itself as a beneficiary of the Western alliance system. The Boris Yeltsin years were an economic catastrophe. Russia had been poor but powerful. Now it was even poorer and held in contempt by other countries, and Russians believed they had been systematically looted by Western financiers. Russia didn’t want NATO to bomb Serbia and was ignored. Russia was instrumental in negotiating an armistice between NATO and Serbia, where Serbia agreed to cede autonomy to Kosovo. It did so on the premise that it would participate in the peacekeeping force, but it was excluded by NATO. The Russians believed that they had been told that NATO would not expand into the former Soviet Union. It did. And Russia saw color revolutions in places like Ukraine and Georgia create pro-America, anti-Russia regimes.

The war with Georgia broke out during the worst years of the Iraq and Afghanistan wars when the United States was in no position to respond. Russia’s offensive had less to do with Georgia than with Ukraine, the Baltics and others that were being drawn into the Western alliance. Georgia thought it had an understanding with the U.S., but the U.S. could not deliver. The war sent a message about the value of an American guarantee.

The assumption after the Cold War was that Russia was finished, just as it was assumed after World War I that Germany was finished. They were supposed to accept their status as junior partners of the victorious alliance, just as Germany and Japan did after World War II. But post-war Germany and Japan were helpless; interwar Germany and post-Cold War Russia were simply badly wounded. Men like Hitler and Putin emerged, not moral equivalents but both utterly concerned with their nations’ interests and prepared to act in defense or pursuit of those interests. And so, in August 2008, Russia announced its return, and the reality of geopolitics – put forth incoherently by al-Qaida – re-emerged.

While this was going on, the core economic assumption of the post-Cold War world was crumbling: that the greater the integration of economic systems, the less friction there would be and the greater the tranquility. One feature of this was a heavily integrated economic system, in which the free movement of capital created a nearly frictionless order. The problem with interdependence is that, as rapidly as it can raise and distribute capital, it can also destroy it. The American subprime crisis would have been, in less sophisticated times, something of a local matter. In 2008, derivatives were being sold globally, so when it emerged that they were worthless, the entire global financial system shuddered and was barely stabilized.

Interdependence was also about trade, where it was assumed that the more a country exports, the more efficient its economy is. This forgot the fundamental truth, which is that the seller is hostage to the buyer’s ability to pay for purchases. During the post-Cold War world, when it was assumed that major financial crises were obsolete, this truism seemed outdated. The financial crisis threw the global system into a contraction, making the truism very much real. As the global markets contracted, particularly in Europe and the United States, their ability to buy products declined.

Developing economies that had followed the maxim that they needed to build larger industrial plants than their publics could consume hit a brick wall. They could not sell enough to utilize their plants or pay their employees. They had the choice between unemployment or lending money to dysfunctional producers to maintain workforce and social stability. Meanwhile, debtor nations were suddenly struggling to cover their debts, and net creditor nations rediscovered nationalism.

The assumption of the post-Cold War world was that nationalism interferes with free trade, and free trade is essential to prosperity. This may be true in some abstract sense, but the assumption doesn’t address two questions. First, how long does it take for the benefits to appear? And second, how should the profits of free trade be distributed at home? How many generations will be willing to wait for the benefits to trickle down to them?

All this undermined core assumptions. China did not evolve into a liberal democracy because it was struggling with the collapse of its export markets. Russia and Saudi Arabia assumed that oil prices would remain high, but as demand weakened, they fell along with the prices of other commodities. The interests of European states diverged as creditors tried to collect from debtors that couldn’t or wouldn’t pay. And while inequality was not critical when everyone was gaining, it suddenly became central.

I mark the transformation of the world as the day Lehman Brothers collapsed, signaling that the subprime crisis had made it impossible to simply maintain the post-Cold War system. But the importance of the crisis was in its consequences. Nationalism and class awareness returned, and the elite that was spawned by the post-Cold War world came under heavy pressure globally, particularly in Europe and the U.S.

The multilateral structures are still there, from the EU to the World Bank, but what relevance they have is unclear. The comfort we can take from all this is that it had to happen. Russia was going to re-emerge. China could not continue growing at the rate it was. The EU could not harmonize the interests of Britain and Greece. And the United States would return to asking its historical question: What has the world done for me lately?

In the span of 40 days, the post-Cold War optimism was crushed. The post-war optimism is always crushed by disillusion, then replaced with a new clarity about friends and enemies. This is the point we are at today. And it all started 10 years ago, almost to the day.


Trade war

Tariffs on steel and aluminium are creating some winners

But they are not quite the success President Donald Trump thinks



DONALD TRUMP credits the tariffs he has imposed on steel and aluminium imports, and on a range of Chinese products, with almost magical potency. Either they will force other countries to drop trade barriers and crown him as dealmaker-in-chief, or they will pay down government debt while saving favoured industries. “Plants are opening all over the US, Steelworkers are working again, and big dollars are flowing into our Treasury,” he tweeted on August 4th. How do those claims stack up?

Tariffs are taxes on imports and so will bring some cash to treasury coffers. But comparatively little. In 2017 America’s government borrowed around 3.5% of GDP. Had the new tariffs been in place, and under the (extreme) assumption that the same goods had been imported despite costing more, they would have raised only 0.08% of GDP. Even including all Chinese imports, the number would have risen to just 0.7% of GDP. And that is before considering tariffs’ depressive effects on demand for imports and on economic growth.

There is more substance to the claim that they have brought American furnaces and smelters roaring back to life. The volume of steel imports from the countries hit by tariffs and quotas was 36% lower in June than a year previously. The corresponding fall for aluminium imports was 27% (see chart). As prices have risen, so has production. Steelmakers are using 78% of their capacity, not far off the administration’s goal of 80%. And some idled aluminium capacity is being brought back online.




But production data are volatile, and recent changes are relatively small when taken in historical context. And some of the recent activity would have happened without new trade barriers. Metal prices have been pulled higher by a strong economy. Higher aluminium prices are in part the result of more expensive alumina, one of the main inputs. American sanctions on Rusal, a massive Russian supplier of alumina, and cuts to alumina production in Brazil because of environmental problems, have left aluminium makers feeling insecure about supply.

Those higher prices are a burden for businesses that use metals, which account for a far higher share of American jobs. They are doubly disadvantaged as inputs become pricier and overseas competitors can undercut them. Some have requested exemptions from the tariffs, only to be blocked by official objections from some of the biggest American steelmakers, which claim that they can supply the supposedly scarce products. But tariffs were not intended to help metal consumers, after all.

More strikingly, even some of those whom protectionism was supposed to help are grumbling. The loudest complaints are about the inclusion of Canada in the list of countries thwacked by trade barriers, which has damaged a highly integrated economic area. Even the United Steel Workers Union, a strong supporter of the tariffs overall, criticised Canada’s inclusion. (It represents workers on both sides of the border.)

In the first quarter of 2018, 52% of American steel exports went to Canada. Those are now being hit with retaliatory tariffs. On August 6th Alcoa, a large aluminium producer, requested a tariff exemption of its own so that it could import aluminium from its Canadian subsidiary to America. It had previously reported that tariffs had raised its costs by around $15m in the second quarter of 2018 (less than the extra profits from higher aluminium prices).

Some producers within both industries do not smelt metal from scratch but recycle or process it instead. It is in their interests for their inputs to be cheap. So far aluminium processors (which account for 97% of employment in the industry) seem to have passed the extra costs on to their buyers. But in the long run higher prices could encourage a switch to different materials. Aluminium competes with steel for use in cars, and with glass in drinks containers.

The big question is whether any revival can be sustained. In the short term, tariffs are more likely to bring older, relatively inefficient steel plants back online than to stimulate new long-term investments, for the simple reason that the president could withdraw the tariffs at any moment. The newest aluminium smelter in America is around 40 years old. If primary aluminium production revives sustainably, it will be because American producers can access cheap, reliable energy.

And tariffs do nothing to address the underlying complaint of American steel and aluminium producers: that state support gives Chinese producers an unfair advantage that has them pumping out production as job losses mount elsewhere. Populist policies can often deliver short-term results. The question for Mr Trump is whether his are worth the cost, and how long the benefits can last.


8 Measures Say A Crash Is Coming, Here's How To Time It

by: Lance Roberts


Mark Hulbert recently penned a very good article discussing the "Eight Best Predictors Of The Stock Market," to wit:

"The stock market's return over the next decade is likely to be well below historical norms. 
That is the unanimous conclusion of eight stock-market indicators with what I consider the most impressive track records over the past six decades. The only real difference between them is the extent of their bearishness. 
To illustrate the bearish story told by each of these indicators, consider the projected 10-year returns to which these indicators' current levels translate. The most bearish projection of any of them was that the S&P 500 would produce a 10-year total return of 3.9 percentage points annualized below inflation. The most bullish was 3.6 points above inflation. 
The most accurate of the indicators I studied was created by the anonymous author of the blog Philosophical Economics. It is now as bearish as it was right before the 2008 financial crisis, projecting an inflation-adjusted S&P 500 total return of just 0.8 percentage point above inflation. Ten-year Treasuries can promise you that return with far less risk."

Here is one of the eight indicators, a chart of Livermore's Equity-Q Ratio which is essentially household's equity allocation to net worth:
 
 
The other seven are as follows:
 
 
 
As Hulbert states:
"According to various tests of statistical significance, each of these indicators' track records is significant at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine. 
However, the differences between the R-squared of the top four or five indicators I studied probably aren't statistically significant, I was told by Prof. Shiller. That means you're overreaching if you argue that you should pay more attention to, say, the average household equity allocation than the price/sales ratio."
"No matter, how many valuation measures I use, the message remains the same.  
From current valuation levels, the expected rate of return for investors over the next decade will be low."
 
This is shown in the chart below, courtesy of Michael Lebowitz, which shows the standard deviation from the long-term mean of the "Buffett Indicator," or market capitalization to GDP, Tobin's Q, and Shiller's CAPE compared to forward real total returns over the next 10 years. Michael will go into more detail on this graph and what it means for asset allocation in the coming weeks.
 

The Problem With Valuation Measures

First, let me explain what "low forward returns" does and does not mean.
  • It does NOT mean the stock market will have annual rates of return of sub-3% each year over the next 10 years.
  • It DOES mean the stock market will have stellar gains in some years, a big crash somewhere in between, or several smaller ones, and the average return over the decade will be low.
This is shown in the table and chart below which compares a 7% annual return (as often promised) to a series of positive returns with a loss, or two, along the way. (Note: the annual average return without the crashes is 7% annually also.)
 
 
 
From current valuation levels, two percent forward rates of return are a real possibility. As shown, all it takes is a correction, or crash, along the way to make it a reality.

The problem with using valuation measures, as Mark Hulbert discusses, is that there can be a long period between a valuation warning and a market correction. This was a point made by Eddy Elfenbein from Crossing Wall Street:

"For the record, I'm a bit skeptical of these metrics. Sure, they're interesting to look at, but I try to place them within a larger framework. 
It's not terribly hard to find a measure that shows an overvalued market and then use a long time period to show the market has performed below average during your defined overvalued period. That's easy. 
The difficulty is in timing the market. 
Even if you know the market is overpriced, that doesn't tell you much about how to invest today."
 
He is correct.
 
So, if valuation measures tell you a problem is coming, but don't tell you what to do, then Wall Street's answer is simply to "do nothing." After all, you will eventually recover the losses… right?
 
However, getting back to even and actually reaching your financial goals are two entirely different things as we discussed recently in "Crashes Matter."
 
 
 
There is an important point to be made here. The old axioms of "time in the market" and the "power of compounding" are true, but they are only true as long as the principal value is not destroyed along the way. The destruction of the principal destroys both "time" and "the magic of compounding."
 
Or more simply put - "getting back to even" is not the same as "growing."
 
Is there a solution?

Linking Fundamentals To Technicals

I have often discussed an important point in reference to our portfolio management process:
"Fundamentals tell us 'what' to buy or sell, technicals tell us the 'when.'"
Fundamentals are a long-term view on an investment. From these fundamental underpinnings, we can assess and assign a "valuation" to an investment to determine whether it is over or undervalued. Of course, in the famous words of Warren Buffett: 


"Price is what you pay. Value is what you get."
 
In the financial markets, however, psychology can drive prices farther, and further, than logic would dictate. But such is the nature of every stage of a bull market cycle where the "momentum" chase, or rather the physical manifestation of "greed," comes to life. This is also the point where statements such as "this time is different," "fundamentals have changed," or a variety of other excuses, are used to justify rampant speculation in the markets.
 
Despite the detachment from valuations, as markets continue to escalate higher, the fundamental warnings are readily dismissed in exchange for any data point which supports the bullish bias.
 
Eventually, it has always come to a rather ignominious ending.
 
But why does it have to be one or the other?
 
Currently, the Equity Q-ratio, as graphed above, is at levels that have historically denoted very poor future returns for investors. In other words, if you went to cash today, it is quite likely that over the next 10 years, the value of your portfolio would be roughly the same.
 
However, before that "mean reverting event" occurs, the market will most likely continue to advance. So, there you are, sitting on the sidelines waiting for the crash.
"Damn it, I am missing out. I should have just stayed in."
The feeling of "missing out" can be overpowering as the momentum driven market rises. Like gravity, the more the market rises, the greater the pull to "jump back in" becomes. Eventually, and typically near the peak of the market cycle, investors capitulate to the pressure.
 
Understanding that price is a reflection of short-term market psychology, the trend of prices can give us some clue as to the direction of the market. As the old saying goes:
"The trend is your friend, until it isn't."
While the Equity Q-ratio implies low forward returns, technical analysis can give us the "timing" as to when "psychology" has begun to align with the underlying "fundamentals".
 
In the chart below, we have added vertical "gold" bars which denote when negative price changes warrant reducing equity risk in portfolios. (The chart uses quarterly data and triggers a signal when the 6-month moving average crosses the 2-year moving average.)
 
 
Since 1951, this "equity reduction" signal has only occurred 17 times. Yes, since these are long-term quarterly moving averages, investors would not have necessarily "top ticked" and sold at the peak, nor would they have bought the absolute bottoms. However, they would have succeeded in avoiding much of the capital destruction of the declines and garnered most of the gains.
 
The last time the Equity-Q ratio was above 40% was during the late 2015/2016 correction, and the technical signal warned that a reduction of risk was warranted.
 
The mistake most investors make is not getting "back in" when the signal reverses. The value of technical analysis is providing a glimpse into the "stampede of the herd." When the psychology is overwhelmingly bullish, investors should be primarily allocated towards equity risk. When it's not, equity risk should be greatly reduced.
 
Unfortunately, investors tend to not heed signals at market peaks because the belief is that stocks can only go up from here. At bottoms, investors fail to "buy" as the overriding belief is the market is heading towards zero.
 
In a recent post, It's Not Too Early To Be Late, Michael Lebowitz showed the historical pain investors suffered by exiting a raging bull market too early. However, he also showed that those who exited markets three years prior to peaks, when valuations were similar to today's, profited in the long-run.
 
While technical analysis can provide timely and useful information for investors, it is our "behavioral issues" which lead to underperformance over time.
 
Currently, with the Equity Q-ratio pushing the third highest level in history, investors should be very concerned about forward returns. However, with the technical trends currently "bullish," equity exposure should remain near target levels for now.

That is until the trend changes.
 
When the next long-term technical "sell signal" is registered, investors should consider heeding the warnings.
 
Yes, even with this, you may still "leave the party" a little early.
 
But such is always better than getting trapped in rush for the exits when the cops arrive.


Isolationism is the wrong charge to level at Donald Trump

The president still participates in the world — just not in the way his critics want

Janan Ganesh


Mike Pompeo and Donald Trump. The president has an unspoken bargain with his party: each ideological faction gets to wet its beak © Getty


Consider some headlines from the serious press over the past year. “Why Americans should fight Donald Trump’s isolationism”. “Trump’s Neo-isolationism won’t work”. “How the GOP embraced the world — and then turned away”. Another, “What Trump calls nationalism looks more like isolationism”, at least argues the case, instead of supposing it as a premise.

This case — that the US is shunning the world — is seconded by a former president. George W Bush flags the “dangers of isolation”. The foreign minister of France worries about “retreat”. These critics know the history they are slyly evoking. Insularity predates the republic, held up its participation in the second world war and saw in the millennium with the presidential campaigns of Pat Buchanan. American quietists doubt that Providence went to all the trouble of gifting them bounteous land, shielded by oceans from the world’s vicissitudes, only for governments to quest abroad.

If Mr Trump ever belonged in this paleoconservative lineage, he has long since broken from it. Of course, caprice, aggression and technical incompetence mar his foreign policy. He has goaded allies and succoured enemies. He is on his fourth national security adviser. Such is the fragmentation of his team, one of these days a cheeky European will wonder aloud who to call if they wish to speak to America.

Isolationism, however, is a strange slur against a government that is active to a fault. These things evade measurement, but it is unclear whether the American presence in the world, taken in the round, has retracted since the presidency of Barack Obama. The US has flinched from treaties and institutions, no doubt, while throwing itself into other modes of foreign policy.

Cross-reference the headlines about isolation with actual events. This week, Mr Trump restored US sanctions against Iran. His mistrust of the Islamic Republic informs a wider Middle East plan that takes in the cultivation of Saudi Arabia. He is the only US president to have met a North Korean head of state. He has struck Syria with air power to enforce his predecessor’s red line. He has threatened violence against other enemies. He wants a larger military and a “ space force” as its sixth branch. He has sent more troops to Afghanistan, against his first instinct.

This is an odd kind of isolation. Nor would his party have worn the real thing. Mr Trump owes his grip on eminent Republicans to cravenness on their part and ruthlessness on his. But there is an unspoken bargain at work, too. The deal is that each ideological faction gets to wet its beak. For religious conservatives: judicial nominees. For business: tax cuts. And for security hawks, such as secretary of state Mike Pompeo: a US that is active in the world. Even on trade, where a true isolationist would aspire to autarky, Mr Trump never entertains the idea. He sticks to bilateral strong-arming, which throws up the spectacle — so grim to a free trader — of countries “pledging” to buy billions of dollars in American manufactures as if in some geo-economic telethon.

The point is not that these are good foreign policies. The point is that these are foreign policies. When critics press international engagement on Mr Trump, they mean engagement of the kind that they — and I — favour. But it can take other forms. The US still participates in the world: less so than before in some respects (see the bean-counting pettiness about Nato), but more so in others (such as Afghanistan). The aggregate picture is too mixed to bear the name “isolation”.

“Chauvinism” is more like it. Richard Haass of the Council on Foreign Relations suggests “abdication”, but even this implies across-the-board retreat from the baseline that Mr Trump inherited.

Which takes us back to his predecessor. All told, is this president less engaged than the last one? Mr Obama honoured the institutional architecture of the postwar west. He knew friends from enemies in a way that should embarrass Mr Trump. He was never a pacifist. Still, he brought to foreign policy a kind of reckless caution. He sometimes heeded the costs of action over the costs of passivity. Syria is a gruesome case in point. He was candid about this prudence, too, drawing down in Afghanistan to favour “nation-building at home”. The World As It Is, by his adviser Ben Rhodes, is a tale of high-minded people slowly caving to realism, right down to its clinical, VS Naipaul-ish title.

Thinking back, what was Mr Obama’s dictum “Don’t do stupid stuff” if not quietism in millennial demotic? The US was not so intrepid in its globalism two years ago. It is not such a recluse now.