What a Cycle!

Sixteen years ago, I considered myself a rookie trader on
the floor of the Chicago Mercantile Exchange. Bright eyed and eager to learn, I
followed every market I could. I actively traded the S&P 500 but, I always
went in early for the currency and interest rate openings, as well. I actively
and, knowingly took advantage of any of the major market players willing to
have a cup of coffee with me. The economic times were significantly different
than those of today. Trading volume was ushering in a major stock market bull-
run, even as memories of the ’87 crash still lingered. The trading floors were
flush with people who made more in one day than most make in a year or some, in
a lifetime. The technology wave was just beginning to trickle in and financial
modeling was at the forefront of quantitative investment strategies.

I still come in early and I still actively trade the stock
indices. I still actively and knowingly pick the brains of the market players I
am fortunate enough to gain an audience with. Sixteen years later, I find
myself at the beginning of the cycle…..again.

I know many of you are thinking that I must be nuts.
However, if you give me a chance to explain, I think I can tease this out in
terms simple enough for myself to understand. I’ve read so much over the last
month that I feel like I’ve learned an entirely new language. Separating the
wheat from the chaff and allowing myself an opportunity to collect my thoughts,
thank goodness for rainy weekends, I’ve come to the conclusion that we’re near
equilibrium and will extend beyond the mean before finally reverting and
building a base very similarly to the process of the early 1990’s.

Economically, the circumstances couldn’t be more different.
In the 90’s, many of the excesses of the eighties had already been purged. The
savings and loan crisis had been effectively dealt with (net cost- 85 billion) and
the stock market crash provided everyone with a whole new perspective on what
risk really was. Interest rates had been coming down for more than a year,
falling from 7.25% to under 3% in less than a year. The U.S. Dollar was still
king having been defended effectively from the Pound by George Soros. This
helped check global inflation and kept commodity prices low while commodity
demand remained, primarily, domestic. Finally, on a quantitative note, the
S&P 500 was at 415 and had a price/earnings ratio of 19.6.

Trading volumes are soaring as technology has removed so
many of the barriers between the pits, the customers and finally, the world.
Money has never moved at a more rapid pace (good or bad).  This same technology brought with it a
generation of misguided applications. Historically, it will be my generation
that brought computer modeling to the financial and commodity markets. We are
the poster generation for “GIGO” garbage in – garbage out. Computer modeling
and optimization provided us with “statistically valid” risk models that would
allow us to take on more leverage and increase the bottom line. Apparently, the
one market excess able to survive the savings and loan crisis as well as the
’87 crash was greed.

History has proven time and time again that there is no
economic free lunch. The tech boom of the ‘90’s made millionaires out of John
Doe’s the same way that the crash made overnight millionaires out of pit
traders. Intelligence and ability should never be confused with being in the
right place at the right time. The separation of those with ability from those
with geographical good fortune can only be told over the course of time. The
trading pits took away the free lunch of pit traders (The Epitome of Free
Trade) just as the dot com bust erased other, unearned fortunes. Currently, it
is the financial industry being forced to endure their comeuppance. Their
computer modeled diversification of bundled risk and carefully designed
tranches sold to global institutions allowed them to over leverage low interest
rates and put people into homes and businesses that should never have been put
into existence. The models that were designed were put into action based on
their ability to compress risk while adding to the bottom line. Does anyone
remember Long Term Capital Management or Enron?

Finally, it is the long term global nature of hubris and
contrition that drives the long term cycles of the stock market. Contrition is
clearly the leading factor since October. Fortunately, just like the oil
market, we have tools to tell us when the fat part of the move may be over.
Fundamental analysis of the Commitment of Traders Report to find under and overvalued markets
fairly successfully while our humility has allowed us let the markets tell us
just what over and undervalued means in real terms. I’ve been writing for more
than six months that the stock market will revert to its mean… and then some.
Markets always overshoot. If this is a normal bear market, we can assume the
following set of parameters.

ratios decline by approximately 60%. The peak for this run was around 43.

decline is approximately 30% form peak.

length is around 14 months.

If we look at these figures, it appears as though it’s going
to be a gloomy holiday season. I believe we entered an, “official” bear market
at a 20% decline from market peaks. Depending on the index, this started in
July. The P/E ratio, even with today’s declines, remains near fair value, at 17
and change. Just as markets tend to overshoot on the upside, so too do they
overshoot on the downside. We will grind our way through and there will be
rallies and failures, just as there always are. The question investors should
be asking themselves is, “How do I best manage my way through this period
without affecting my long term goals or, giving into short term emotions?”

I believe that this is where the commodity futures trading industry, through
stock index futures like the S&P 500, Dow, Nasdaq 100 and Russell 2000
should be employed. They are offered in a wide range of sizes and can be
tailored to cover most any equity portfolio. The margins and account sizes are
exceptionally favorable, as well. Currently, an individual can still protect
$30,000 worth of tech holdings with a $5,000 account.

Individuals who don’t utilize the futures markets to limit
their losses on the way down or, to maximize their return on the way up are
simply hiding their heads in the sand and pretending that they don’t know better.
Any investor who feels they are responsible for the lifestyle of their
retirement should act in their own best interest and take advantage of these
opportunities. I thank goodness that I can see the beginning of the next
sixteen years far more clearly than I was able to see the beginning of the
first sixteen.


Trading in Volatile Markets

Trading in Volatile Markets

Last week’s events bring to mind some important truths about
commodity trading. Many traders categorize themselves as fundamental traders or,
technical traders or, systematic traders. However, the best traders find it
hard, at best, to implement their particular trading plan when market
volatility explodes and the rules are changed in the middle of the game. Let’s
frame the market’s activity before we dissect its impact on trading styles.

First of all, the financial markets are in mass liquidation.
The stock market saw 150 year old stalwarts reduced to bankruptcy. The bond
market was experiencing priced in risk premiums higher than those witnessed
during 9/11. The commodity markets were under mass liquidation as Commodity
Index Traders, the managers of the long only commodity funds, were being forced
to liquidate on the way down to reduce leverage. Daily ranges were increasing
and cash balances were fluctuating wildly, regardless of trading style. The news
events that were surfacing daily were materially impacting not only the
markets, but the exchanges and trading strategies, directly.

For this discussion, it’s important to know a bit about each
trader’s style. Fundamental trader are long term, macro -economic investors who
place a high emphasis on, “being right in the long run.” They typically follow the Commitment of Traders reports or the USDA grain reports. Many fundamental
traders may claim to have, “been early,” when entering a market and are therefore
placed immediately into a losing trade. This is not a knock on their trading style
or, any of the others that I’m about to mention. Fundamental traders rarely
trade with stop losses because they don’t want to stopped out of a “noisy
market.” Generally speaking, they focus on a particular market or, sector and
tend to know it very, very well. Their idea of a “fair price,” or “fair value,”
leads them in and out of the market based on their models.

Technical traders rely on oscillators, indicators, trend
lines and so forth. Elliot wave analysts, Fibonacci traders and pattern
recognition also fall into this category. As long as the trend lines hold, the oscillator
bounces back or the wave count is right, it works. Pattern traders can trade
within the framework of their studies and historical models of what has worked
for them in the past and use them as best they can to forecast future price

Lastly, systematic traders focus their time on the
development of algorithms and buy/sell programs that, once implemented, provide
quantitative entry and exit commands. The implementation of the system comes
down to the trader’s ability and willingness to execute the program’s commands
exactly as the program specifies.

How has last week’s action affected trader’s ability to
trade? The fundamental traders have had to sit through some exceptionally wild
equity swings. Looking at last week’s moves, was the fundamental trader right
to say that gold was too cheap in the $700’s or is the fundamental trader right
to assume that gold is too expensive in the $900’s. There is no question that
crude was overpriced at $140+ per barrel but, I don’t know anyone who sold at
$120 on the way up and still had it for the ride back down.  If the fundamental trader can’t stay with the
position, does it really matter if he’s proven right, over time? This is where
the old saying, “The markets can remain irrational longer than a trader can
remain solvent,” comes from. Look at last week’s ranges and multiply them times
their point values. The mini S&P 500 was 11 points higher for the week
(+$550). However, the range was 155 points or, $7750 per contract. That’s a lot
of risk for someone buying the market’s $550 return.

Technical traders had many of their classic signals trigger
trading opportunities. Overbought and oversold readings were both pegged in
various markets. Index traders had VIX readings over 40 and TRIN indicators
over 900. Commitment of Traders Index followers received both buy and sell
signals and lastly, several trend lines were violated, only to have the markets
reverse course the following day.

System traders didn’t fare any better, I’m afraid. There
were some day trading opportunities but, anything given one day was taken back
over the next day or two. Therefore, losing trades abounded. Also making
matters worse, the exceptional volatility led to execution issues. Markets that
normally had a tight bid and offer with many contracts available on either side
suddenly found themselves at a loss for executing multiple contract orders at a
single price. Other orders, like stop or, market orders were executed far worse
than any slippage allowance that was modeled into the system’s creation.

The very short point of this very long article is that, sometimes,
it’s most important to focus on each trade as a single trade. Execute that
trade as if in a vacuum. When markets are swinging like they have been,
fundamentals can be thrown out the window, technicals taken with a grain of
salt and systems employed as best as execution will allow. Discretionary
traders have been provided with a tremendous opportunity. The ability to
synthesize macro- economic dynamics in a fluid environment filtered through the
lens of technical analysis and executed with the precision of a binary program
are the discretionary trader’s harvest season. This ability to take any trade
as simply, “a trade,” and maximize the profit and loss characteristics of each,
through careful monitoring, is the discretionary trader’s opportunity to ride
gold for $150 dollars in two days or squeeze 300 basis points out of the yield
curve. These are the, “Hero” moments that I will never be a part of as we continue
to try and carve something out of the middle.

Andy Waldock




Lost in the Confusion

Lost in the Confusion


Amid the roar of the financial chaos and their ability to affect,
seemingly every market, one sector has been quietly building a base and should
be renewing buying interest. Remember back in late May and June during the
wettest spring ever when the concerns of crop planting were making the local
news? The ensuing run up in grain prices soon had everyone beating the drum of ethanol’s
demand on corn prices and the cost of bread, chips and cereal.

Since the grain markets peaked in July, many of them have
sold off considerably. Soybeans have fallen from an all time high of $16.47
down to $11.00 per bushel. Corn and wheat are also off 30 – 35%. The main
reasons for this sell off has been the exceptional growing conditions helping to
make up for the wet spring as well as the typical seasonal pattern the grain
markets have of selling off once the crop has been planted. Further pressure
was added this summer by the rise in the U.S Dollar and the global demand
reduction associated with increasing purchase costs as a result of the exchange

Soybeans and wheat continued to decline this past week amid
the global uncertainty of the financial markets and a general flight from
derivative based investment. However, corn made its low of $5.00 per bushel
more than a month ago. Also, the corn market failed to make new lows amid the
financial panic. Technically, corn need only close above $5.67 to setup a
genuinely bullish breakout of a double bottom.

Fundamentally, while the corn crop has grown well, the late
planting has had an effect on the maturation process of the crop. The saying
being floated by the corn pundits is, “Looks good from the road but not in the
field.” This year’s crop will be especially vulnerable to an early frost or
cool late summer as the late planting is affecting the finishing of the crop.
Lastly, and most importantly, the global corn crop began this year at one of
the tightest stocks to usage ratio on record. Basically, this means that there
was less of the previous year’s corn crop still available in the pipeline at
the beginning of this year’s planting season.

It appears in the USDA grain reports that given the acreage planted, the projected
yield and demand for this year’s crop will do little to ease this issue. While
we move to global “on demand inventory,” it’s important to know that commodity futures
supplies are static. Government’s can print money. Stock exchanges can forbid
short selling and banks can be bailed out. However, neither the U.S. Federal
Reserve nor the European or English Central Banks can create more corn. Those
who have been losing sleep over the next financial market, “Breaking News
Bulletin,” may wish to consider something more grounded.



P –

F –


The High Cost of the Last Penny

This is a very succinct article on the high cost, both monetary and human, of squeezing the last dime out of a product and the consequence of “earnings blindness” and not being able to see past this quarter’s numbers.

There are some positive investment strategies touched upon below. We can help with short term metals and treasury commodity futures trading. Our customers’ accounts are in segregated funds and are not borrowed against or loaned out as collateral.

We haven’t been around as long as Lehman but, I am the second generation and I believe in the process of handing the reigns over to the next generation. Therefore, we will continue to endeavor in catching the fat part of the trade and leaving the tails to those who are unwilling to see the head.


The Fall of Lehman: How To Fix It – Part II

By Michael Lewitt

History has a funny way of humbling men. So do markets. Perhaps the most disturbing aspect of Lehman Brothers’ fall is that it comes almost seven years to the day after 9-11. That day was supposed to teach us humility, and the fall of Lehman, coming six months after the collapse of Bear Stearns and coupled with Merrill Lynch’s disappearance as an independent company, are the result of a complete lack of humility on the part of those executives charged with leading the world’s most important purveyors of capital in the post-9-11 world. For all the talk of pulling together in the wake of the terrorist attacks that shook America to the core and that supposedly set our priorities straight, Wall Street rushed headlong back to its mindless pursuit of profits and speculation without consideration for the consequences of its actions. Now the chickens have come home to roost.

In April 2008, HCM published a controversial essay entitled “How To Fix It,” in which we outlined our (unsolicited) recommendations for how to correct the excesses that led to the credit crisis that began in mid-2007 and brought us to this historic day. We are republishing that issue of the market letter by attachment for those who did not read it the first time. Our key recommendations, which seemed much more radical in April than they do today, were the following:

  • Improve financial industry regulation and replace substance over form in the regulation we have.
  • Place absolute leverage limitations on financial institutions at much lower levels than the 30:1 levels that led to this crisis.
  • Place an absolute limitation on hedge fund leverage.
  • Regulate Wall Street compensation by basing it on multiple years’ performance, add clawbacks and high water marks, and limit cash compensation that is paid out and weakens these firms’ balance sheets.
  • Tax private equity firms’ carried interests at ordinary interest rates rather than capital gains rates and restrict private equity firms’ ability to go public.
  • Outlaw off-balance sheet entities.
  • Reinstitute the uptick rule with respect to short selling.

Finally, we made the point that too much economic activity in the United States was aimed at speculation rather than production. For example, the equity markets are increasingly dominated by quantitative investment strategies that are driven by considerations that are totally divorced from considerations of fundamental value. At the same time, the credit markets are increasingly utilized to finance change-of-control transactions for private equity firms that are done simply because low cost financing is available, not because a project is going to add to the productive capacity or capital account of the nation. As we wrote in that April issue, “t some point, society has to figure out that the way an investor earns his money is even more important than the amount of money he makes. This is why human beings were vested with moral sentiments, so they could distinguish the quality of human conduct from the quantity of its results.”

These changes cannot and will not be effected simply by legislative fiat. It is incumbent upon the gatekeepers of capital – the fiduciaries that make the decisions about allocating capital – to bring discipline to the system. This will require a rethinking of their priorities and a willingness to add to their investment calculus considerations that exceed their own narrow interests about short-term investment returns. Our system requires a new concept of fiduciary duty that encompasses systemic as well as single-firm interests, and that focuses to a greater degree on risk-adjusted returns than raw numerical returns. Obviously the forces that led to this weekend’s events have been building for many years, and the changes needed to fix the system will not be made overnight. But we should not let this occasion pass to reflect on what has occurred.

Imagine You Are On the Deck of The Titanic (Because You Are)

It is clear to us that the Federal Reserve and United States Treasury are not underestimating the enormity of the crisis. Continuing to write checks to bail out the private sector would have been the wrong decision, but the fallout is going to be severe. The next domino to fall may be the insurance giant, American International Group, Inc. (AIG), which is facing credit rating downgrades that will force it to post more collateral (that it doesn’t have )on a large volume of credit insurance contracts. AIG is a much larger systemic threat than Lehman Brothers ever was, so this situation is profoundly serious. In HCM‘s judgment, investors should not try to pick a bottom in today’s or this week’s market. The market is going to experience extraordinary volatility today and over the immediate future. Play the market at your own risk and only with money you can afford to lose. The indices are heading significantly lower, as we have previously forecast. Gold, short-term U.S. Treasuries, short-term Swiss and German government paper, the Swiss franc, and certain Asian currencies like the Singapore dollar are the safest places to park your cash for the moment. The U.S. dollar continues to be debased (less against the Euro, which remains compromised, than against Asian currencies and the Swiss franc), particularly by the startling and historic decision by the Federal Reserve to accept equity securities at its discount window. If nothing else, that decision alone suggests the enormity and depth of the crisis we are facing. We never thought we’d live to see the day that the American central bank would accept equity as collateral for loans. We have to admit that took us by surprise and made us very nervous.

When Pigs Fly

Hurricane season has brought about some unintended
consequences which are my job to find as a commodity broker. The one least likely to make the news is their effect on hog and
cattle prices. Every time people are forced to flee and cities lose their
power, we see a rally in meat prices. Loss of power creates a temporary demand
shock to the system. Every individual and grocer has to trash every piece of
meat in their home or store.

This didn’t actually hit until the blackout in August of ’03.
I was prepared for the stock market’s initial sell off followed by a huge rebound
based on the public selling the market off on the terrorism fears and buying it
back with a vengeance when it was ruled out. That trade lasted from Sunday
night until Tuesday morning, just as I planned. However, over the next week and
a half, I watched the hog and cattle markets climb and climb. At that time, I
didn’t have the forethought to forecast the demand shock of the replacement
value of all of the perishable goods.


Hurricane            Date                      Change Hogs                      Change Cattle

Floyd                     9/16/99                                11%                                        11%

Blackout               8/14/05                                17%                                        28%

Isabel                    9/18/03                                19%                                        9%

Ivan                       9/16/04                                7.8%                                      2%


&                             8/05                                       4.5%                                      9%


Rita                        9/24/05                                5%                                          3.5%


This morning’s trade will most likely, send all asset
classes lower. Obviously, this will include the commodity futures markets. Take
advantage of this morning’s weakness to establish long positions in perishable markets

Growing Rift in OPEC

Wednesday’s OPEC meeting was quite noteworthy. The headline news stories tell us that OPEC agreed to cut crude oil production by 520,000 barrels a day. The headlines won’t tell you that the ties that bind OPEC are unraveling at a wonderful rate for crude consumers. The addition of Hugo Chavez and Argentina’s emergence on the global oil market, combined with Russia’s re-emergence as one of Europe’s primary suppliers have created a rift within OPEC that seems to be widening. The political aspirations of the membership as well as their allegiances with non-OPEC nations are forcing the once cloistered group into open public confrontation.

Note the following excerpts from the Associated Press’ coverage of the meeting.….Behind the scenes, the 13-nation energy cartel juggled the conflicting interests of Saudi Arabia and Iran – and brought oil and gas giant Russia closer into the fold by agreeing to sign a cooperation agreement with the Kremlin.

However,…… “Russia does not want to be in OPEC because it means adhering to quotas which is not what Russia wants,” she (Cornelia Meyer) said. “Russia does not want to comply with anyone’s wishes but the Kremlin’s.”

Furthermore,…. Saudi Arabia’s clout is key for Washington. President Bush visited Riyadh twice this year to push an oil production increase. The Saudis answered by ramping up production by about 500,000 barrels a day.

If we combine the above statements, with the following statements, from Douglas A. McIntyre from 24/7 Wall St. we can see that the primary information to take from these meetings is the impossibility of coexistence between a fractious OPEC combined with the differing agendas of new powers on the block, Argentina and Russia.

…Saudi Arabia walked out on OPEC yesterday. It said it would not honor the cartel’s production cut. It was tired of rants from Hugo Chavez of Venezuela and the well-dressed oil minister from Iran.
As the world’s largest crude exporter, the kingdom in the desert took its ball and went home.
As the Saudis left the building the message was shockingly clear. According to the New York Times, “Saudi Arabia will meet the market’s demand,” a senior OPEC delegate said. “We will see what the market requires and we will not leave a customer without oil.”

Basically, ….”OPEC needs that for the Saudis to have any credibility in terms of pricing, supply, and the ongoing success of its bully pulpit. By failing to keep its most critical member it forfeits its leverage.”

Bill Siedman, market analyst and respected voice on CNBC, sees this dissent as a good thing. To paraphrase his comments, “There is no question that dissention within the oil cartel will lead to better price discovery of the true value of a barrel of oil. The Saudis are leading the dissent. They are the largest contributing member and have the largest oil reserves. They also possess the infrastructure to put these reserves on the market rapidly. They are, essentially, the leaders within the cartel. When push comes to shove, it’s their ball to call.The important thing to note from these meetings is that since 9/11 and Katrina, the U.S. and the world at large have been pushing alternative fuel technology. Even though our energy plan lacks coherence, the combination of the auto industry’s push towards fuel efficiency, the private sector’s growth of alternative power generation and academia’s funding surge channeled towards alternative energies are all effectively undermining the future power of petroleum.

The primary members of OPEC see the writing on the wall. They are using their petroleum revenues to diversify the economies of their countries. They are investing in infrastructure and technology at an unprecedented rate. Even though these processes take many years to develop, I believe we will be able to look back on this meeting, in the wake of $145 oil and say, “That was when it all started to unravel.”


Spread Trading Gold vs. Platinum

Many customers have been asking spread strategy questions
and last week’s action in the gold and platinum markets provides us with a
wonderful opportunity to have this discussion.

Take a look at the
attached chart.

The red line on the
bottom is how much gold is worth relative to platinum (gold close/platinum
close). This is a monthly chart and you can see that the spread, along with
platinum, have broken their trends going back to ’01. This means that the
prices of these two metals are converging. One should be short platinum and
long gold. The way I see it, the price of platinum has been beaten up far worse
than gold. I think the global slow- down scenario may be impacting the
manufacturing base for platinum more than inflationary/deflationary issues are
effecting the speculative nature of the gold market. Gold has also held above
its trend line, in spite of the U.S. Dollar’s significant rally.

Profitable spread trading requires more than predicting the
general directions of the two markets involved. The size of the contracts, tick
size and volatility also need to be considered. In this example, there is only
one platinum contract to choose from. However, there are four actively traded gold
contracts in three different sizes and on two different exchanges. Even the simple
assumption that one full size contract of each should be sufficient would be
incorrect. Recently, platinum is moving around $67 per day in the futures
market and gold is moving around $25 per day. Would it be appropriate to try to
even these out by trading two gold contracts versus one platinum contract?

Here is the method I use as a commodity broker to appropriately size my spread
trades. First of all, I calculate the average range for each market relative to
the time frame I expect my trade occur in. In this case, I am looking at
monthly charts. Therefore, I calculate the 21 day average range for each market
and come up with $21 for gold and $67 for platinum. The next step is to
multiply each of these average daily ranges by the market’s point value. Gold
is $21 X $100 = $2100 per day average movement. Platinum gives us $67 X 50 =
$3350 in average per day movement.

Clearly, one full
size contract of each is not an even spread. Now, since we know that we only
have one platinum contract to work with, our only opportunity for proper sizing
in the futures market (there are option strategies available, as well), is to look
at the list of available gold contracts. One full size gold contract gets us to
$2100 per day and leaves us with a $1200 per day deficit to make up. Chicago’s mini
sized gold contract is 33.2 oz. (1/3 full size). That would bring our total to $2793
on the gold side of the trade. This won’t square the ledger. New York’s mini
sized gold contract is 50 oz. (1/2 full size). That would make our total $3150.
That’s pretty close. Obviously, the other option is to use two Chicago mini
contracts and bring our total to $3486. At this point, it comes down to
personal bias. Would one rather be more or, less long gold relative to

I hope this brief description answers more questions than it
creates. However, please feel free to post any ideas, comments or, issues.

Georgia and Iraq – New President’s Nightmare

The following is from a weekly newsletter I read. I think they do a wonderful job of taking the “spin” off of the media’s issue of the moment. They also provide possible strategic reasons for actions taken around the world. This article has nothing to do with trading. However, it does provide some context for my job as a commodity broker and the issues our next President is going to face.    



By George Friedman

The United States has been fighting a war in the Islamic world since 2001.
Its main theaters of operation are in Afghanistan and Iraq, but its
politico-military focus spreads throughout the Islamic world, from Mindanao to
Morocco. The situation on Aug. 7, 2008, was as follows:

  1. The
    war in Iraq
    was moving toward an acceptable but not optimal solution.
    The government in Baghdad was not pro-American, but neither was it an
    Iranian puppet, and that was the best that could be hoped for. The United
    States anticipated pulling out troops, but not in a disorderly fashion.
  2. The
    war in Afghanistan
    was deteriorating for the United States and NATO
    forces. The Taliban was increasingly effective, and large areas of the
    country were falling to its control. Force in Afghanistan was
    insufficient, and any troops withdrawn from Iraq would have to be deployed
    to Afghanistan to stabilize the situation. Political
    conditions in neighboring Pakistan
    were deteriorating, and that
    deterioration inevitably affected Afghanistan.
  3. The United
    States had been locked in a confrontation with Iran over its nuclear
    , demanding that Tehran halt enrichment of uranium or face U.S.
    action. The United States had assembled a group of six countries (the
    permanent members of the U.N. Security Council plus Germany) that agreed
    with the U.S. goal, was engaged in negotiations with Iran, and had agreed
    at some point to impose sanctions on Iran if Tehran failed to comply. The
    United States was also leaking stories about impending
    air attacks on Iran by Israel or the United States
    if Tehran didn’t
    abandon its enrichment program. The United States had the implicit
    agreement of the group of six not to sell arms to Tehran, creating a real
    sense of isolation in Iran.

Special Topic Page

In short, the United States remained heavily committed to a region
stretching from Iraq to Pakistan, with main force committed to Iraq and
Afghanistan, and the possibility of commitments to Pakistan (and
above all to Iran
) on the table. U.S. ground forces were stretched to the
limit, and U.S. airpower, naval and land-based forces had to stand by for the
possibility of an air campaign in Iran — regardless of whether the U.S. planned
an attack, since the credibility of a bluff depended on the availability of

The situation in this region actually was improving, but the United States
had to remain committed there. It was therefore no accident that the Russians
invaded Georgia on Aug. 8
following a Georgian attack on South Ossetia.
Forgetting the details of who did what to whom, the United States had created a
massive window of opportunity for the Russians: For the foreseeable future, the
United States had no significant forces to spare to deploy elsewhere in the
world, nor the ability to sustain them in extended combat. Moreover, the United
States was relying on Russian cooperation both against Iran and potentially in
Afghanistan, where Moscow’s influence with some factions remains substantial.
The United States needed the Russians and couldn’t block the Russians.
Therefore, the Russians inevitably chose this moment to strike.

On Sunday, Russian Prime Minister Dmitri Medvedev in effect ran
up the Jolly Roger
. Whatever the United States thought it was dealing with
in Russia, Medvedev made the Russian position very clear. He stated Russian
foreign policy in five succinct points, which we can think of as the Medvedev
Doctrine (and which we see fit to quote here):

  • First, Russia recognizes the primacy of the fundamental
    principles of international law, which define the relations between
    civilized peoples. We will build our relations with other countries within
    the framework of these principles and this concept of international law.
  • Second, the world should be multipolar. A single-pole
    world is unacceptable. Domination is something we cannot allow. We cannot
    accept a world order in which one country makes all the decisions, even as
    serious and influential a country as the United States of America. Such a
    world is unstable and threatened by conflict.
  • Third, Russia does not want confrontation with any
    other country. Russia has no intention of isolating itself. We will
    develop friendly relations with Europe, the United States, and other
    countries, as much as is possible.
  • Fourth, protecting the lives and dignity of our
    citizens, wherever they may be, is an unquestionable priority for our
    country. Our foreign policy decisions will be based on this need. We will
    also protect the interests of our business community abroad. It should be
    clear to all that we will respond to any aggressive acts committed against
  • Finally, fifth, as is the case of other countries,
    there are regions in which Russia has privileged interests. These regions
    are home to countries with which we share special historical relations and
    are bound together as friends and good neighbors. We will pay particular
    attention to our work in these regions and build friendly ties with these
    countries, our close neighbors.

Medvedev concluded, “These are the principles I will follow in carrying out
our foreign policy. As for the future, it depends not only on us but also on our
friends and partners in the international community. They have a choice.”

The second point in this doctrine states that Russia does not accept the
primacy of the United States in the international system. According to the
third point, while Russia wants good relations with the United States and
Europe, this depends on their behavior toward Russia and not just on Russia’s
behavior. The fourth point states that Russia will protect the interests of
Russians wherever they are — even if they live in the Baltic states or in
Georgia, for example. This provides a doctrinal basis for intervention in such
countries if Russia finds it necessary.

The fifth point is the critical one: “As is the case of other countries,
there are regions in which Russia has privileged interests.” In other words,
the Russians have special interests in the former Soviet Union and in friendly
relations with these states. Intrusions by others into these regions that
undermine pro-Russian regimes will be regarded as a threat to Russia’s “special

Thus, the Georgian
conflict was not an isolated event
— rather, Medvedev is saying that Russia
is engaged in a general redefinition of the regional and global system.
Locally, it would not be correct to say that Russia is trying to resurrect the
Soviet Union or the Russian empire. It would be correct to say that Russia
is creating a new structure of relations
in the geography of its predecessors,
with a new institutional structure with Moscow at its center. Globally, the
Russians want to use this new regional power — and substantial Russian nuclear
assets — to be part of a global system in which the United States loses its

These are ambitious goals, to say the least. But the Russians believe that
the United States is off balance in the Islamic world and that there is an
opportunity here, if they move quickly, to create a new reality before the
United States is ready to respond. Europe
has neither the military weight nor the will to actively resist Russia.
Moreover, the Europeans are heavily dependent on Russian natural gas supplies
over the coming years, and Russia can survive without selling it to them far
better than the Europeans can survive without buying it. The Europeans are not
a substantial factor in the equation, nor are they likely to become

This leaves the United States in an extremely difficult strategic position.
The United States opposed the Soviet Union after 1945 not only for ideological
reasons but also for geopolitical ones. If the Soviet Union had broken out of
its encirclement and dominated all of Europe, the total economic power at its
disposal, coupled with its population, would have allowed the Soviets to
construct a navy that could challenge U.S. maritime hegemony and put the
continental United States in jeopardy. It was U.S. policy during World Wars I
and II and the Cold War to act militarily to prevent any power from dominating
the Eurasian landmass. For the United States, this was the most important task
throughout the 20th century.

The U.S.-jihadist war was waged in a strategic framework that assumed that
the question of hegemony over Eurasia was closed. Germany’s defeat in World War
II and the Soviet Union’s defeat in the Cold War meant that there was no
claimant to Eurasia, and the United States was free to focus on what appeared
to be the current priority — the defeat of radical Islamism. It appeared that
the main threat to this strategy was the patience of the American public, not
an attempt to resurrect a major Eurasian power.

The United States now faces a massive strategic dilemma, and it has limited
military options against the Russians. It could choose a naval
, in which it would block the four Russian maritime outlets, the Sea
of Japan and the Black,
Baltic and Barents seas. The United States has ample military force with which
to do this and could potentially do so without allied cooperation, which it
would lack. It is extremely unlikely that the NATO council would unanimously
support a blockade of Russia, which would be an act of war.

But while a blockade like this would certainly hurt the Russians, Russia is
ultimately a land power. It is also capable of shipping and importing through
third parties, meaning it could potentially acquire and ship key goods through
European or Turkish ports (or Iranian ports, for that matter). The blockade
option is thus more attractive on first glance than on deeper analysis.

More important, any overt U.S. action against Russia would result in
counteractions. During the Cold War, the Soviets attacked American global
interest not by sending Soviet troops, but by supporting regimes and factions
with weapons and economic aid. Vietnam was the classic example: The Russians tied
down 500,000 U.S. troops without placing major Russian forces at risk.
Throughout the world, the Soviets implemented programs of subversion and aid to
friendly regimes, forcing the United States either to accept pro-Soviet
regimes, as with Cuba, or fight them at disproportionate cost.

In the present situation, the Russian response would strike at the heart of
American strategy in the Islamic world. In the long run, the Russians have
little interest in strengthening the Islamic world — but for the moment, they
have substantial interest in maintaining American imbalance and sapping U.S.
forces. The Russians have a long history of supporting Middle Eastern regimes
with weapons shipments, and it is no accident that the first world leader they
met with after invading Georgia was Syrian
President Bashar al Assad
. This was a clear signal that if the U.S.
responded aggressively to Russia’s actions in Georgia, Moscow would ship a
range of weapons to Syria — and far worse, to Iran. Indeed, Russia could
conceivably send weapons to factions in Iraq that do not support the current
regime, as well as to groups like Hezbollah. Moscow also could encourage the
Iranians to withdraw their support for the Iraqi government and plunge Iraq
back into conflict. Finally, Russia could ship weapons to the Taliban and work
to further destabilize Pakistan.

At the moment, the United States faces the strategic problem that the
Russians have options while the United States does not. Not only does the U.S.
commitment of ground forces in the Islamic world leave the United States
without strategic reserve, but the political arrangements under which these
troops operate make them highly vulnerable to Russian manipulation — with few
satisfactory U.S. counters.

The U.S. government is trying to think through how it can maintain its
commitment in the Islamic world and resist the Russian reassertion of hegemony
in the former Soviet Union. If the United States could very rapidly win its
wars in the region, this would be possible. But the Russians are in a position
to prolong these wars, and even without such agitation, the American ability to
close off the conflicts is severely limited. The United States could massively
increase the size of its army and make deployments into the Baltics, Ukraine
and Central Asia to thwart Russian plans, but it would take years to build up
these forces and the active cooperation of Europe to deploy them. Logistically,
European support would be essential — but the Europeans in general, and the
Germans in particular, have no appetite for this war. Expanding the U.S. Army
is necessary, but it does not affect the current strategic reality.

This logistical issue might be manageable, but the real heart of this
problem is not merely the deployment of U.S. forces in the Islamic world — it
is the Russians’ ability to use weapons sales and covert means to deteriorate
conditions dramatically. With active Russian hostility added to the current
reality, the strategic situation in the Islamic world could rapidly spin out of

The United States is therefore trapped by its commitment to the Islamic
world. It does not have sufficient forces to block Russian hegemony in the
former Soviet Union, and if it tries to block the Russians with naval or air
forces, it faces a dangerous riposte from the Russians in the Islamic world. If
it does nothing, it creates a strategic threat that potentially towers over the
threat in the Islamic world.

The United States now has to make a fundamental strategic decision. If it
remains committed to its current strategy, it cannot respond to the Russians.
If it does not respond to the Russians for five or 10 years, the world will
look very much like it did from 1945 to 1992. There will be another Cold War at
the very least, with a peer power much poorer than the United States but prepared
to devote huge amounts of money to national defense.

There are four broad U.S. options:

  1. Attempt to make a settlement
    with Iran
    that would guarantee the neutral stability of Iraq and
    permit the rapid withdrawal of U.S. forces there. Iran is the key here.
    The Iranians might also mistrust a re-emergent Russia, and while Tehran
    might be tempted to work with the Russians against the Americans, Iran
    might consider an arrangement with the United States — particularly if the
    United States refocuses its attentions elsewhere. On the upside, this
    would free the U.S. from Iraq. On the downside, the Iranians might not
    want —or honor — such a deal.
  2. Enter into negotiations with the Russians, granting
    them the sphere of influence they want in the former Soviet Union in
    return for guarantees not to project Russian power into Europe proper. The
    Russians will be busy consolidating their position for years, giving the U.S.
    time to re-energize NATO
    . On the upside, this would free the United
    States to continue its war in the Islamic world. On the downside, it would
    create a framework for the re-emergence of a powerful Russian empire that
    would be as difficult to contain as the Soviet Union.
  3. Refuse to engage the Russians and leave
    the problem to the Europeans
    . On the upside, this would allow the
    United States to continue war in the Islamic world and force the Europeans
    to act. On the downside, the Europeans are too divided, dependent on
    Russia and dispirited to resist the Russians. This strategy could speed up
    Russia’s re-emergence.
  4. Rapidly disengage from Iraq, leaving a residual force
    there and in Afghanistan. The upside is that this creates
    a reserve force
    to reinforce the Baltics and Ukraine that might
    restrain Russia in the former Soviet Union. The downside is that it would
    create chaos in the Islamic world, threatening regimes that have sided
    with the United States and potentially reviving effective intercontinental
    terrorism. The trade-off is between a hegemonic threat from Eurasia and
    instability and a terror threat from the Islamic world.

We are pointing to very stark strategic choices. Continuing the war in the
Islamic world has a much higher cost now than it did when it began, and Russia
potentially poses a far greater threat to the United States than the Islamic
world does. What might have been a rational policy in 2001 or 2003 has now
turned into a very dangerous enterprise, because a hostile major power now has
the option of making the U.S. position in the Middle East enormously more

If a U.S.
settlement with Iran
is impossible, and a diplomatic solution with the
Russians that would keep them from taking a hegemonic position in the former
Soviet Union cannot be reached, then the United States must consider rapidly
abandoning its wars in Iraq and Afghanistan and redeploying its forces to block
Russian expansion. The threat posed by the Soviet Union during the Cold War was
far graver than the threat posed now by the fragmented Islamic world. In the
end, the nations there will cancel each other out, and militant organizations
will be something the United States simply has to deal with. This is not an
ideal solution by any means, but the clock appears to have run out on the
American war in the Islamic world.

We do not expect the United States to take this option. It is difficult to
abandon a conflict that has gone on this long when it is not yet crystal clear
that the Russians will actually be a threat later. (It is far easier for an
analyst to make such suggestions than it is for a president to act on them.)
Instead, the United States will attempt to bridge the Russian situation with
gestures and half measures.

Nevertheless, American national strategy is in crisis. The United States has
insufficient power to cope with two threats and must choose between the two.
Continuing the current strategy means choosing to deal with the Islamic threat
rather than the Russian one, and that is reasonable only if the Islamic threat
represents a greater danger to American interests than the Russian threat does.
It is difficult to see how the chaos of the Islamic world will cohere to form a
global threat. But it is not difficult to imagine a Russia guided by the
Medvedev Doctrine rapidly becoming a global threat and a direct danger to
American interests.

We expect no immediate change in American strategic deployments — and we
expect this to be regretted later. However, given U.S. Vice President Dick
Cheney’s trip to the Caucasus region, now would be the time to see some
movement in U.S. foreign policy. If Cheney isn’t going to be talking to the
Russians, he needs to be talking to the Iranians. Otherwise, he will be writing
checks in the region that the U.S. is in no position to cash.

National City, Key or, Iraqi Govt. Bonds?

As it relates to continually tightening credit, we need only look at the current credit spreads to see just how tough it is to procure operating cash in corporate America. Currently, according to the Merrill Lynch US Financial Index, the typical cost to borrow money has increased from 70 basis points over Treasuries to over 390 basis points over Treasuries. A 500% increase in borrowing costs will put the clamps on any new business spending. Now, to put this into perspective, please note the following from John Mauldin.<![endif]–>

it can get much worse for some banks. In the “for what it’s worth”
department, Iraq’s bonds are now considered safer than those of many US banks.
The country’s $2.7 billion of 5.8% bonds due 2028 have gained 45% since August
2007, according to Merrill Lynch & Co. indexes. Investors demand 4.84
percentage points more in yield to own the debt instead of Treasuries, down
from 7.26 percentage points a year ago. The spread is narrower than for notes
of Ohio banks National City Corp. and KeyCorp, suggesting Baghdad may be safer
for bond investors than Cleveland. National City and KeyCorp, based in
Cleveland, have debt ratings of A and spreads of 959 basis points (9.59%) and
7.55 basis points (7.55%), respectively. Iraq debt has no ratings. Clearly the
market is ignoring the rating agencies which give the banks an “A&quo
t; rating. Their debt is priced at the junk level. Go figure. (Source: Bloomberg)”

For those of us here in Ohio, like myself, that light puts a whole new spin on where WE are in this economic cycle.