Global crisis foment, slight return

In the comment section, super loyal Nate says…

“Whoa whoa whoa. I gotta comment on this article, ESPECIALLY after your next newer one. You haven’t sounded this worried about the economy since the blog began, and the comparison makes it striking. This isn’t April 1, is it?Are you yanking our cranks with your talk to pulling the majority of your money out? It seems like you see more of a depression in the coming year than at any time in the past year. Does this imply you are planning to re-buy in a month, or once this Iran scare plays out or fizzles? The doom and gloom of this article juxtaposed on the following one is enough to make one’s head spin. Surely if you are serious about the end of the world from Iran re-arranging oil shipping routes, then clothes retailers doing slightly better or worse is somewhat irrelevant? Does that imply you went off on a bit of a hypothetical tangent, or lent a little more credibility to the likelihood of Iran doing something dumb?”

It’s like this…

Investing is as much about preservation of capital as it is about appreciation of capital. We have two forces in opposition right now: the economy emerging from a deeeep recession and an impending actual crisis with Iran.

The financial markets have priced in the end of the recession since June. In fact, there was a sense for awhile that the market had returned to its wild horse mode as valuations were beginning to look a little rich. However, there has been a nice sideways, treading water sort of movement over the last 4 weeks. That indicates that most market participants are sober in their evaluation of prospects. Hallelujah.

For those who invested in March and April returns have been about what one would expect to earn over the course of 5-7 years (!). This introduces a particular bias into an investor’s mind: sell. Especially when valuations look fairly valued to overvalued. But the mitigating factor is the financial results of U.S. businesses in the just-ended third quarter. If the results are better than expected – read: better than is priced into the values of the underlying businesses – then there is still potentially some upside.

This is the “appreciation of capital” form of wealth accumulation. Note, because of the investment returns of the spring and summer and the commensurate rich valuations, it requires an investor to be greedy enough to want more than 5-7 years worth of appreciation in a short period of time. In all honesty, that’s not me.

The post about the Iranigans (Iran + shenanigans) is about the “preservation of capital.” The financial markets have been pricing in the end of the recession. As an investor you have to stop and ask yourself what other major things are happening that are not being priced in. One is the possible misjudgment of the markets about the quality and magnitude of third quarter business results. But to me third quarter results look appropriately priced or only slightly underpriced. On the other hand, the brewing crisis in Iran looks absolutely unpriced and unappreciated by the market. This opinion, in conjunction with the recognition that we have seen 5-7 years of appreciation in 6-7 months, to me looks like a sell decision.

In terms of what I feel about the economy right now. I think the economy is stronger now than it has been since the blog began over a year ago. However, it is still fragile and a Middle Eastern nuclear crisis will collapse the financial markets and send the economy back into recession.

Note: as a portfolio manager this is not the sort of call that I could have made. Mutual fund shareholders and their boards of directors do not hire equity managers to manage cash. But I see a clear (and please forgive the homily, because normally I hate them) “bird in the hand” – 5 to 7 years of appreciation in half a year – vs. “two in the bush” – possible third quarter upside – situation here.

The real question regarding the Iranian crisis is not what the U.S. will do to Iran; but what will Israel do to Iran? Israel is right on the doorstep of Iran. So assuming that Iran is near to completing a nuclear weapon, which it looks like they are, how patient can Israel afford to be with the peaceful options of diplomacy or likely very weak gasoline sanctions? Israel in the past has unilaterally bombed nuclear facilities of Muslim countries nearby. Because their national security is at risk, what would you do if you were the executive in charge of Israel? Exactly.

So what will the likely Iranian response be? To disrupt shipping in, or mine the Strait of Hormuz. The Strait is home to 80% of oil traffic in the world. That will draw the U.S. into the conflict, shutdown the flow of oil for several weeks (a very big deal), and draw the oil speculators into the markets, sending oil prices up hugely. This is the alternative Iranian “nuclear” scenario.

Right now tea leaves have to be read because none of the participants in this crisis are speaking publicly (a bad sign); especially since every day for most of 2009 there was some noise about Iran. The Russians late last week broke the silence to say that they absolutely supported Iran and the development of its nuclear technology. So the Russians aren’t backing down. That puts pressure on the U.S. The response from the U.S. was that it is considering building Ballistic Missile Defense sites in the Ukraine – right on Russia’s doorstep. This latter U.S. statement actually shocked the Russians and was intended to pressure them. As you can see a giant game of nuclear chicken is taking place. Meanwhile, the most important player, Israel, has said nothing. Again, a bad sign.

To me selling right now looks smart. To lock in gains of 5-7 years and leaving the potential upside of a great 3rd quarter on the table, and to wait for the Iranigans to blow over seems prudent. As always, context is critical. The context right now is that the global economy, while recovering, is recovering very weakly. A spike in oil prices right now would throw the economy back in to recession. And how quickly would it take for the financial markets to respond to a Middle Eastern nuclear crisis? About 3-4 trading sessions, in my opinion.

The remaining question is: for how long should we wait? I am guessing that the Iran crisis will resolve itself by the end of the year. If not it will be a sign that Israel is content to allow diplomacy and sanctions to unfold. And even if that isn’t what Israel is thinking, the global economy will likely have recovered enough to not freak out investors if an attack occurs. If you feel you absolutely want to be invested then look at shares of oil companies that pay a dividend.

In terms of the contrast between the “global crisis foment” post and the subsequent economic stats post…sorry. However, it is important to continue to track the economy even if we are sitting in cash waiting for the Iranigans to become non-impactful.

Jason