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Apparently, Aziz was only
partially correct in the denial. Based on news reports, it appears more
likely that the rumors were circulated as part of a plan to find out the
whereabouts of Iraqi leaders before the start of the war. The hope was to sap
the enemy's will and destroy the chain of command at the inception of the
war. This led to the coalition air and missile strikes on the Dora oil
refinery complex on March 18.
On
March 11, the S&P 500 Index ($INX) closed at 800.73 and the Dow
Jones Industrial Average ($INDU) closed at 7,524.03, both six-month
lows. Rumors began to swirl that the war rally had already ended. The rumors
reached all the remaining weak bulls left in the market and led to the
sapping of their morale just before one of the biggest rallies in history, a
13% gain to March 21 with eight consecutive positive days from the March 11
bottom.
Both
factoids are examples of the importance of taking the indirect approach to
clashes of mind against mind. In the case of the war, the clash is between
the coalition powers and Iraq. In the case of the market, the clash is
between the bulls and bears.
The
indirect approach to war has been thoroughly explored over more than 2,500
years. The classic work in the field is Sun Tzu's "The Art of War,"
written in 500 B.C. It has been extended, refined and modernized by B. H.
Liddell Hart in "Strategy", by Edward Luttwak in "Strategy:
The Logic of War and Peace"; and by Von Senger in "The Book of
Strategems." We shall use these books as a foundation to see what
insights market strategists can derive from them.
The line of least expectations
The
fundamental principle of indirection in military strategy is to strike and
maneuver where the enemy least expects it. That path is what Edward Luttwak
calls the "line of least expectations." It was the path taken by
the Allies for the D-Day invasion in World War II, when they landed in
Normandy after convincing the Germans that the main attack was planned in the
north at the Pas de Calais. The deception was so successful that even after
the Normandy landing, the Germans expected the major attack to be at Calais.
The
most recent famous case of deception in battle came in the Gulf War of the
early 1990s, with General Norman Schwarzkopf's left-hook flanking maneuver.
At
the time, the Iraqi military assumed that navigation through the desert was
impossible because there were few if any landmarks (or "assets")
amidst the shifting sand dunes. Since an attack from the desert was
"impossible," the Iraqis were certain that they would be engaged
primarily along the Saudi-Kuwait border and massed their defensive forces
there. To encourage this expectation, Schwarzkopf did indeed assemble an
enormous phalanx precisely where the Iraqis expected them, and sent in a
noisy Marine Corps group from the Arabian Gulf to seal the deception.
The
Iraqis started retreating down the middle, north from the Saudi-Kuwait
border.
When
the ground assault began, not only were the Iraqi military forces caught
totally off guard by an attack from their rear, but Schwarzkopf's flanking
maneuver cut off their escape route. His left hook was a textbook
illustration of Hart's principle of surprise and indirection: "In
strategy the longest way round is often the shortest way there -- a direct
approach to the object exhausts the attacker and hardens the resistance by
compression, whereas an indirect approach loosens the defender's hold by
upsetting his balance."
Not
only is the enemy unprepared for an indirect assault, but the discomposure
engendered by it in the enemy's mind prevents them from marshalling an
effective counter.
The
current conflict is replete with indirection and deception. All the talk
about surrendering, the deaths of key leaders, the overwhelming mobilization
to come, the use of doubles, pre-recorded videos, the camouflage of hiding among
civilians -- all these could have come right out of Sun Tzu: "He will
conquer who has learnt the artifice of deviation, such as the art of
maneuvering."
The
applications of the line of least expectations to markets are numerous. Let's
start with the unprecedented recent rally. It occurred shortly after a report
of February consumer confidence at its lowest level in 11 years. The Dow
closed at 7,891 on the day the report came out. Bearish sentiment among
market commentators was at fever pitch. The Spec Duo was overwhelmed with
mail from readers telling us that they had decided to just sell everything,
they couldn't take it anymore, their retirement plans were ruined, and they
were planning to go back to work.
The cycles are ever-changing
The
greater the superiority of force on one side of a war, the less the need for
indirect action. Thus, as one side becomes stronger, it changes tactics. This
was nicely illustrated by the example of Israeli war strategy. During the
1960s and 1970s, the balance of power favored their enemies. They tried to
avoid direct clashes, relying on commando raids and surprise attacks. But
after a while, the adversaries began to expect the unexpected.
During
the Lebanon War in 1982, the Syrians were not surprised in the least by the
Israeli advance with an entire armored division that had maneuvered into the
battle through a single one-lane road. But they were very surprised when
Israel changed its tactics to a direct frontal attack in broad daylight.
"Obviously", Luttwak concluded, "by 1982 with their
paradoxical style of war so fully exposed in countless previous engagements,
for the Israelis, the line of least expectation could only be the most direct
frontal approach."
The
applications of the theory of ever-changing cycles are ubiquitous in markets.
In our article "11 stock-slugging tips from Ted Williams",
we noted that value stocks go through periods when they are better than
growth, only to be superseded by the opposite. We also pointed out that a
good time to go with anti-trend strategies is after they have been doing
well.
When
we said this, the MAR-Hedge Trend Following Advisers Subindex was at an all
time high of approximately 1,400 versus its 118 starting point in January
1983. The Spec Duo was being besieged with sardonic remarks laid upon
critique such as, "If you're so smart, how come you don't own the Boston
Red Sox, like John Henry. You were the one that went under, not him."
That
was apparently time for cycles to change, just when the public was most
engaged. We're informed by friends in the industry that most trend-following
funds suffered one of their worst weeks ever in the week ended March 21, with
losses on the order of 15%-to-25%. That's guaranteed to happen in markets
like this; when stock go down, bonds and oil and gold go up, and the dollar
goes down. When the trends reverse, all the latent energy of the trend
followers must move prices in an opposite direction.
Our
book "Practical Speculation" (see the link at left) is replete with
numerous other examples of how the cycles are ever-changing. Our favorite is
Julian Simons' explanation of why real commodity prices are constantly
decreasing. Greater population and incomes create scarcities in the short
run. Prices rise but " the higher prices present opportunity and prompt
investors to seek solutions. These solutions eventually lead to prices
dropping lower than before the scarcity occurred".
Our
friend Adam Robinson, a chess master, along with our partner Gitanshu Buch,
both of whom assisted us with many aspects of our column, add that surprise
and a shifting balance between offense and defense is crucial in games. At a
certain point, the direct approach is the indirect approach. Mr.
Robinson is reminded of Bobby Fischer's playing for the first time in his
life the queen's gambit against Boris Spassky, a known expert in the line, at
a crucial point in their 1972 match.
The importance of flexibility
Is
there one American who hasn't been impressed with Gen. Tommy Franks' constant
emphasis that the coalition's plan in Operation Iraqi Freedom is a flexible
one designed to react to all contingencies? The approach is a direct
application of B. H. Liddell Hart's admonition to create an elastic offense and
defense. Regrettably, the Germans adopted this strategy in World War II with
their blitzkrieg. The strategy was to use mobile tanks to overrun the enemy
at the point of least resistance, drive through quickly and form a wedge in
the enemy's defense, and then finally, having passed the enemy's point of
greatest strength, to attack from both sides.
Flexibility
in market activities is as important as in war. Position sizes must always be
low enough to exit when the future balance of risk and reward changes. The
plan of action must be related to the costs of getting in and out of
positions, especially taking into account the bid-asked spread and
commissions.
For
example, low-priced stocks often have high commissions and spreads that can
come to 5% each side. Ask yourself if you really expect to be able to
overcome a 10% roundtrip cost in the very efficient markets that always
exist. Reserves for unexpected contingencies must be maintained. Another area
where flexibility is paramount is in position size relative to your capital
on hand. The market always has a tendency to go just far enough to force you
out of your good positions if you are undercapitalized.
The
benefits of the indirect approach are not limited to war and markets. We
agree with Liddell Hart that it is a principle of philosophy that applies to
all spheres, "its fulfillment was seen to be the key to practical
achievement in dealing with any problem where the human factors
predominate". We have enumerated on our Web site (see link at left) many
other applications to markets, and life, in such fields as the war between
the sexes and the mathematical proof by assuming the opposite of the
proposition to be proved. We encourage our readers to contribute their own
examples of indirection by e-mailing us.
But
as health in life is key to health in markets, we report the following from
Dr. David Brooks, chief of laparoscopic surgery at Brigham & Women's
Hospital in Boston: "In medicine, as in life, the indirect approach is
paramount. We look for the simplest approach to modify disease rather than to
try to attack it straight on. Vaccination is an example of that. Indeed, the
major technique of boosting the immune system to fight disease is based on
exploiting deception: tricking the body into defending itself against an
innocuous 'threat' so it will be able to handle a virulent form (of disease)
in the future."
If
investors do not wish to attack their own wealth, they should pay proper
attention to the uses and traps of the indirect approach.
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