Assert a Principle? Measure Market Risk?

Assert a Principle? Measure Market Risk?
David R. Kotok
Cumberland Advisors September 5, 2013



“Assert a principle,” says our Secretary of State, John Kerry. So now we find ourselves in the throes of an unresolved national debate over whether the US should launch cruise missiles at unknown targets in Syria in order to assert a principle formed in the 1925 Geneva Convention.

For nearly a century we have been asserting principles and seeing results like those in Iraq and Afghanistan. In my generation, we watched an assertion of principles in Southeast Asia. I seem to recall some chemicals were used then. Oh, my. What has our national leadership done to us now?

Today, our views are focused on risk and markets. This commentary is not about whether to bomb Syria. We may do it, or we may follow the UK Parliament’s lead and watch a legislative body emasculate what remains of our president’s prerogatives. We will learn that outcome soon enough.

Now let’s focus on markets and risk. My friend Jeff Saut reminds us of a crucial observation attributed to economist Eliot Janeway (1913-1993): “When the president is in trouble, the stock market is in trouble.”

The president is in trouble. That is the risk at the top of the list. The list is not new; however, it is evolving as each hour passes.

We cannot assume that something is going to happen between the US and Syria. We cannot assume that some type of congressional resolution is going to end up passing both houses of Congress. If it does, we know the President will then be in the corner all over again, having drawn a line for the third time. He may characterize that line as one the world has drawn instead, or the UN, or the Geneva Convention of 1925. But he is the artist now. It will still be Obama’s line if the Congress passes a joint resolution. And it will be Obama’s failure if they do not pass it.

The first time, he did not “assert principles” and intervene when it might have been done by surprise and without allowing the adversary to prepare. He threatened Syria but didn’t enforce the threat, which led to a second warning with another red line but again no action. Now, with more than 1,400 dead from chemical weapon use, he has drawn a third red line. How many dead must be counted before we find ourselves compelled to assert a principle? Or do we not assert a principle except when it is convenient? How do we measure failure to assert a principle?

Geopolitical risk premia are nearly impossible to measure. Sometimes we can see them in interest-rate movements. European debt issues are a recent example.

Sometimes we see them in precious metals. Or, we may see them in currency adjustments.

We can estimate risk reflected in the oil price by looking at the current price and the steepness of the backwardation (declining futures prices) in the curve of the oil price as it goes out in time. Right now, it is very steep. That suggests that oil prices in front months already have a premium factored into them. And that premium is clearly due to geopolitical risk in the Middle East. The steep backwardation suggests the premium is not due to rising global economic robustness.

But other times we cannot measure them until an event occurs and a reaction to a shock follows. AIG was a global enterprise. Its failure triggered a massive adjustment of risk premia. We know what happened after Lehman. Older folks may remember what happened when we bombed Hanoi.

Now what do we know? We know that the US Department of Defense has been subjected to sequestration-induced budget restraints. And we know that, in some cases, training of pilots has been curtailed. Before it became law, the sequester was seen as being so unacceptable that it would not be allowed to happen. Democrats and Republicans, Congress and the White House, all agreed they would not want sequestration to impact national defense capabilities because of the high risks involved.

Now we are about to embark on a military escapade while sequestration is still the law. It is not yet clear that there is any substantive impairment of our capabilities – the sequester has not been in place for long. We hope we do not find out that it has caused damage in any meaningful way. But risk management requires us to say, we do not know.

We face an Obama–Putin divide. Meanwhile, Russian activity in Syria has not been curtailed, and no Russian personnel have been withdrawn. In fact, there are two large amphibious landing ships headed for the Syrian port of Tartus, which Russia uses as a base. Yesterday (September 4), Nightwatch detailed Russia’s recent moves:

The Russian Defense Ministry also said the patrol combatant Neustrashimyy and the large landing ships Aleksandr Shabalin, Admiral Nevelskoy and Peresvet are carrying out missions in the Mediterranean in accordance with operational command plans.

The large landing ships of the Black Sea and Baltic fleets, the Novocherkassk and the Minsk, will join them on 5-6 September. The medium reconnaissance ship SSV-21 Priazovye, which put out from Sevastopol on 1 September, is acting in accordance with special plans of the General Staff.

Each landing ship can hold 500 tons of cargo or ten tanks and 200 soldiers, according to Nightwatch. Think about this as we watch the Defense Department try to figure out what targets to program into our cruise missiles.

Also, think about the nexus of evil that has Iran and Hezbollah aligned with Syria. They have the capacity to do serious damage to US targets everywhere in the world. We can expect retaliation when the Syrians and their allies broadcast images of deaths resulting from US missiles.

Our point here is that risk is high. Market pundits who say this conflict has already been resolved may be right, but we think there are still rocky and uncertain times ahead.

Our dysfunctional, divided government may manage to agree on a resolution regarding Syria, but sequestration and debt-ceiling debates loom ahead. These debates will take place while we are involved in a geopolitical contest with people who receive payments from us and from others around the world for their oil. They use those payments to create ill will and do harm to the Western world.

In this crazy construction, one has to ask whether it is wise to hold a cash reserve at a time when the stock markets of the world, particularly in the US, have enjoyed such enormous gains. At Cumberland, we think the answer to that question is yes.

Post-Labor Day, back at our desks as we enter September, we continue to maintain a high cash reserve in our US ETF accounts and a moderate cash reserve in our global and international accounts. We believe it is too soon to recommit to a fully invested posture.

We draft these comments on the day after the Dow was up 100 points in a post-Labor Day rally. We sold some small pieces into that rally.

We look at the attractiveness of bond market sectors like the 5% level in high-grade tax-free securities and find them very competitive with other options. We are buyers in the long tax-free bond sector, just as we are holding a cash reserve in the stock market sector. In some states, the taxable equivalent yield is approaching 10%.


David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors

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