Why Monetary Policy Will Cancel Out Fiscal Policy

Authored by MN Gordon via EconomicPrism.com,

Good cheer has arrived at precisely the perfect moment.  You can really see it.  Record stock prices, stout economic growth, and a GOP tax reform bill to boot.  Has there ever been a more flawless week leading up to Christmas?

We can’t think of one off hand.  And if we could, we wouldn’t let it detract from the present merriment.  Like bellowing out the verses of Joy to the World at a Christmas Eve candlelight service, it sure feels magnificent – don’t it?

The cocktail of record stock prices, robust GDP growth, and reforms to the tax code has the sweet warmth of a glass of spiked eggnog.  Not long ago, if you recall, a Dow Jones Industrial Average above 25,000 was impossible.  Yet somehow, in the blink of an eye, it has moved to just a peppermint stick shy of this momentous milestone – and we’re all rich because of it.

So, too, the United States economy is now growing with the spry energy of Santa’s elves.  According to Commerce Department, U.S. GDP increased in the third quarter at a rate of 3.2 percent.  What’s more, according to the New York Fed’s Nowcast report, and their Data Flow through December 15, U.S. GDP is expanding in the fourth quarter at an annualized rate of 3.98 percent.

Indeed, annualized GDP growth above 3 percent is both remarkable and extraordinary.  Remember, the last time U.S. GDP grew by 3 percent or more for an entire calendar year was 2005.  Several years before the iPhone was invented.

A Cornerstone Promise of the GOP Tax Reform Bill

But despite closing out the year strong, 2017 won’t be the year when annual U.S. GDP growth finally eclipses 3 percent.  By our rough calculations, annual GDP growth for 2017, using the Q4 estimate, comes out to 2.92 percent.  What to make of it…

Certainly, strong GDP growth is a cornerstone promise of the GOP tax reform bill.  Specifically, the promise is that resultant economic growth will pay for the tax cuts.  Yet based on the work of one group of number crunchers, the expectation that the U.S. economy will produce 3 percent economic growth in 2018 is wishful thinking.  The Tax Foundation, an outfit out of Washington, offered the following assessment:

“According to the Tax Foundation’s Taxes and Growth Model, the plan would significantly lower marginal tax rates and the cost of capital, which would lead to a 1.7 percent increase in GDP over the long term, 1.5 percent higher wages, and an additional 339,000 full-time equivalent jobs.  In 2018, our model predicts that GDP would be 2.45 percent, compared to baseline growth of 2.01 percent.”

To be clear, we don’t know what assumptions went into the Tax Foundation’s Taxes and Growth Model.  Does it factor in the latent effects of quantitative tightening?  Does it assume a total of 3 Fed rate hikes in 2018?  What about the flattening yield curve?

In short, will tightening credit markets offset any boost that tax cuts are expected to deliver to the economy?  In other words, will monetary policy cancel out fiscal policy?

Most likely it will.  Here’s why…

Why Monetary Policy Will Cancel Out Fiscal Policy

Plain and simple, the entire financial system and economy has become fully dependent on cheap and ever expanding credit.  Consumers, the federal government, and corporations have gone hog wild gorging on a decade of artificially suppressed, cheap credit.

Presently, American’s owe $3.8 trillion in outstanding consumer credit – some of which, no doubt, was used to purchase light up reindeer antlers.  Of this, more than $1.2 trillion of consumer spending has been borrowed into the economy over the last decade.  This is consumer spending that has been borrowed from the future into the present.

Similarly, over the last decade the federal government has borrowed and spent over $11 trillion, bringing the federal debt from $9 trillion to over $20 trillion.  That’s more than a doubling of the debt in just 10 years.

But that’s not all.  Corporations have been on a massive borrowing and spending binge too.  Total outstanding nonfinancial corporate debt has jumped from about $3.2 trillion in 2007 to over $6 trillion today.  Again, that’s a doubling of debt over the last decade.

What makes the growth of consumer, government, and corporate borrowing over this period so dangerous – in addition to its pure enormity – is that it was encouraged by the Fed’s artificially low interest rates.  The scale and magnitude of this cheap credit expansion is nothing short of a manic credit bubble.

The point is, as mentioned last week, we appear to be entering a period where the price of credit – specifically, interest rates – rise and, thus, credit contracts.  Naturally, this is occurring at the worst possible time; after everything and everyone has become wholly dependent on cheap, expanding credit.

As the Fed raises interest rates, borrowing costs become more expensive.  With respect to government debt, it will take a larger and larger share of the government’s budget to finance the debt.  This will reduce the funds that the government can spend elsewhere.  Similarly, with respect to consumers and corporations, increasing borrowing costs will subtract from spending and investment.

And this is precisely why monetary policy will cancel out fiscal policy.  And this is precisely why the cornerstone promise of the GOP tax reform bill will come up empty.  And this is precisely why we are all doomed.

And on that cheery note, we’ll conclude our ruminations.

Record Calm Stock Market Gets A Shock

Via Dana Lyons" Tumblr,

After a record run of muted movement, will recent volatility send negative shock waves through stock market?

The recent uptick in stock volatility has some investors on edge (OK, it is mostly just financial news editors on edge). The truth is, while volatility over the past week has seen an increase, it is not all that far away from the historical norm. Last Thursday through Monday, for example, the Dow Jones Industrial Average (DJIA) experienced 3 straight “volatile” days, with daily ranges of between 1% and 1.6% on all 3 days. Looking historically, however, we find that the average daily range in the DJIA over the last 90 years is 1.6%. Even during the current bull market since 2009, the average range is 1.08%. Thus, the recent action should hardly be characterized as volatile.

The reason it perhaps seems so tumultuous is because we are emerging from a long stretch of calm in the market – record calm, at that. Prior to Thursday, the DJIA had gone 72 days without experiencing a daily range as wide as 1%. If that sounds like a long stretch, it’s because it is a record. In fact, the record prior to this recent streak was just 49 days in a run that ended in late February of this year. And prior to 2016, the record going back to 1928, according to our database, was a mere 32-day streak back in 1944 – less than half the recent streak.

Furthermore, historically, there have been just 16 streaks that have lasted as long as 21 days, i.e., 1 month.

Interestingly, this recent streak is the first of any of the 16 that saw 3 straight 1% daily ranges immediately following its culmination. So is mean-reversion starting to rear its volatile head here following the record calm? And is there a nefarious message to the sudden uptick in volatility?

*  *   *

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The Moment The Market Broke: "The Behavior Of Volatility Changed Entirely In 2014"

Earlier today we showed a remarkable chart - and assertion - from Bank of America: "In every major market shock since the 2013 Taper Tantrum, central banks have stepped in (even if verbally) to protect markets. Following the Brexit vote, markets no longer needed to hear from CBs as they rebounded so quickly that CBs didn’t need to respond." As a result, buy-the-dip has a become a self-fulfilling put.

The immediate result of this dynamic has been two-fold: i) investors now buy every dip, or as Bank of America notes, "Investors no longer fear shocks, but love them, as it is an opportunity to predictably generate alpha.", and ii) selling of vol has become a self-reinforcing dynamic, in which lower VIX begets more vol-selling by "yield-starved investors", leading to even lower VIX as the shock that can reset the feedback loop is no longer possible, and thus the strike price on the Fed"s put can not be put to a market test.

These observations prompt BofA"s derivatives expert Benjamin Bowler to ask the rhetorical question: "volatility: new normal or bubble?" and answer: "It"s a bubble." Indeed it is, but absent the abovementioned market-clearing shock, it is difficult, if not impossible to anticipate what can burst this bubble.

In the meantime, the market has spawned some spectacular distortions, including the following observation: "As one measure of volatility, the Dow Jones Industrial Average traded in its tightest trading range since 1900 this year." Here is Bowler:

While asset valuations are not at life-extremes, volatility is. In 2017 the Dow traded in a 110yr record tight trading range, the VIX hit all-time lows, and US equities reversed from sell-offs at near their fastest pace in 90 yrs. Investors no longer fear risk but love it, as it’s another opportunity to harvest “dip-alpha”. Volatility across asset classes has decoupled from uncertainty. Even if seemingly irrational, apathy to all risk has been the right trade and an impossible trend for most to fight – the definition of a bubble.

A bubble, he adds, "induced by years of heavy handed central bank influence, where investors have learned that it has not paid to panic." Bowler asks readers to consider the following:

As one measure of volatility, the Dow Jones Industrial Average traded in its tightest trading range since 1900 this year

Near 90yr records are occurring in the speed that US equities are recovering from dips

The VIX is near 26yr lows despite political & policy uncertainty recently near 26yr highs

Gold call options price less than 1 in 100 chance of rising North Korean tensions in the face of rising North Korean tensions

The above leads Bowler to concludes that "while there is active debate about whether risk-assets like equities and credit are overvalued, it is much harder to argue that currently depressed volatility levels are unsustainable when near 100yr records in terms of low vol and the lack of persistence of any shock are being recorded."

So when did the market "break", and when did the behavior of volatility change so dramatically?

This overarching question has been plaguing Wall Street strategists for much of 2017. In July, we presented one answer from Deutsche Bank"s Aleksandar Kocic who pointed out the divergence between the economic policy uncertainty index and the VIX, which took place roughly in 2012, prompting the derivatives expert to conclude that something "snapped" roughly around that time, or as Kocic said, sometime in 2012 it was as if the markets “lost their capacity to deal with uncertainty.”

Bank of America takes a somewhat different approach, and instead of looking at the divergence between volatility and news - or shock - flow, highlights the moment BTFD became religion.

According to Bowler, "the nature of volatility since 2014 has entirely changed, with volatility shocks retracing at record speed. Investors no longer fear shocks, but love them, as it is an opportunity to predictably generate alpha." This is demonstrated in the following stunning chart which not only shows that every VIX dip is now just an opportunity to buy it, but that the market"s "fragility" is at an all time high based on the surging frequency of vol spike events, which in turn, and paradoxically, reassure investors that a central bank backstop can not be too far away.

BofA is hardly the first to point out this phenomenon: almost exactly one year ago, it was JPM"s "quant wizard" who highlighted precisely the same, if not through the perspective of VIX but the overall market response to recover from "shock" events:

It appears that the time horizon of macro traders has shortened, likely as a result of increased participation of machines and algorithms that are quicker to adjust to significant events and can eliminate trading activity of slower investors. Consider for example the US elections - traders in Japan registered a 5.4% Nikkei drop on the 9th, followed by a 6.7% rally on the 10th, while S&P 500 investors did not register a significant close-to-close move over the election (due to market hours difference). These two days were enough to shift the volatility regime (usually calculated from closing returns) for the whole of 2016 for the Japanese equity market, and leave it unchanged for S&P 500 (e.g. think of rebalancing needs of a hypothetical risk parity fund, or a short volatility strategy based on Nikkei vs. one based on S&P 500). We also noticed that for a number of significant catalysts this year (Brexit, US Election, Italy Referendum) broad expectations were wrong both on the outcome and the directionally forecasted impact. It is possible that the lack of market reaction (or a reaction that went against the accepted narrative) was in part driven by investors’ reluctance to transact (“two negatives equal a positive”).

Ah yes, the infamous "investor reluctance to transact", which has only gotten worse as we hinted in our "trader paralysis" post, and which Goldman demonstrated vividly just last month when the bank showed that hedge fund turnover has now dropped to an all time low as virtually nobody trades anymore.

Whatever the reason behind the broken market, however, whether it is central banks, machines, algos, risk parity funds, vol-targeting strategies,  self-reinforcing "Pavlovian" dynamics, or simply traders no longer trading, the question is what comes next? While we will have a more detailed breakdown in a subsequent post, here are Bowler"s three questions, and several answers of what to expect in 2018:

As we enter 2018, three questions are top of mind when it comes to volatility:

1. Is 2018 the year when vol begins to normalize, or is this the “new normal”?


2. As low vol threatens to sow the seeds of the next crisis, how will this end?


3. Where does vol go in the longer-run; can we ever see the old-normal return?

 

Vol likely to rise off extreme lows; ’87 crash unlikely, but so is VIX averaging 20 While we will look at each question in more detail in turn, the short answers are:

1. Higher not lower vol: We think 2018 is most likely to see higher (not lower vol) as the Fed builds more “ammunition” in terms of rate-hikes leaving them less sensitive to financial market conditions (i.e. pushing the Fed put strike lower), and as CB balance sheets peak in 2018.


2. Vol bubble more likely to deflate than explode: While the risk of “fragility” shocks due to positioning and feeble liquidity is high, we think the level of leverage today, which is lower compared to the last time vol was this depressed (2007), does not present the same risks as then.


3. Vol to remain low vs. long-run average: However, to the extent we remain in a low inflation/low rates environment, we may also remain in a lower than normal vol environment. So while VIX near 9 is an unsustainable bubble, VIX at 20 (the long-run average) may also be unsustainable in a slower growth world.

And BofA"s conclusion:

What to watch for? In a world slaved to rates, inflation remains key

 

From a macro perspective, we continue to believe unexpected inflation is the kryptonite for volatility. Inflation presents a “triple whammy”, first driving economic vol higher, destabilizing bond markets (and putting bond/equity correlation at risk), but importantly handcuffing central banks from being as sensitive to financial markets. In other words it both drives fundamental risk higher and significantly impairs the protection markets have become dependent on. Rising rates vol is key to watch.

 

How bad can it get? From here Aug-15 shock likely but ’87 crash is improbable

 

Interestingly, while the world is hyper-focused on how big the “short-vol” trade is, history shows that any liquidity shock large enough to create an equity bear market (20% fall in equities, similar to 1987 or LTCM crisis) provides a forewarning in terms of rising volatility first (look for S&P vol to double from 10 to 20). Fragility shocks (similar to Aug-15) that happen without warning remain the bigger risk today in our view.

 

So, how do you trade this? Long “vol beta”, cheap options for direction

 

The most important question is, how do you trade this environment where investors have given up on risk (or have learned to love it as buying dips has been “free money”). Evidence of a “bubble in apathy” is strong, and we believe it is unsustainable. However, the problem with any bubble is not recognizing you are in it but rather timing its end. Hence the key is finding trades that will profit from a change in environment but carry well and hence don’t require perfect timing. The beauty of today’s low vol is that it can be cheap to own optionality (for example for upside stock replacement) which affords the benefit of not having to time when markets may peak.

 

Does this mean short vol is a bad idea? No, but it needs to be smartly managed

 

Importantly, believing that today’s low vol is unsustainable does not mean all short vol positions are bad. Don’t forget, owning any risk asset (equity, credit etc.) is a short-vol trade. The key is finding the best short vol opportunity (highest risk-adjusted returns), while managing downside risks appropriately. Harvesting rich vol risk-premia is key to funding cheaper long vol positions elsewhere.

An Autopsy of Lowest Selling Pressure EVER: S&P 500, NASDAQ 100 and DJIA Futures DataViz

E-mini S&P 500 Futures (ES)

 

Based on candlestick wick analysis and data across all three primary US futures contracts, there is less selling pressure than ever before.

Not since xyz, not since insert year here... there is less selling pressure than ever.  But everything"s awesome, right?  Just BTFD, right?

If "real technical analysis" was stranded on a desert island with only one wish: #RealTA would ask for candlesticks.  And currently there is a complete and utter lack of top wicks – more so than ever before in the history of ES, YM, and NQ futures. The relentless rally of the past 75 trading sessions has resulted in the lowest 50-day, 100-day, 200-day, and 500-day totals of bottom wicks since ES futures began trading.

So, while volatility and average true range have been missing (read as: kidnapped), so has any semblance of selling pressure; and the top wicks that indicate it.

Aside from an unexpected flash crash type scenario, futures are unlikely to plot a long-term or short-term top without indication of waning buying pressure and/or intensified selling pressure.  At some point in the central bank liquidity orgy flow induced future, all this buying pressure will exhaust itself and we will likely see evidence of an actionable top – in the form of increased frequency and size of top wicks – indicating that selling pressure has arrived (read as: awoken from a morphine overdose induced coma) and that equity "markets" are finally ready to chill.

 

 

 

 

 

Here is another astonishing datavizualization of market structure and ES volume, courtesty of dataviz legend @nanexllc... starting at 11am during the 12/01 session, S&P 500 futures registered record-breaking volume by trading more contracts during that hour than at any other since at least 2005. 

 

The hour beginning at 11am last Friday had the highest $Volume traded in S&P500 futures since at least 2005. 2nd highest was flash crash. $ES_F pic.twitter.com/m9MikNo4H6

— Eric Scott Hunsader (@nanexllc) December 4, 2017

 

 

Is today’s session a bearish omen of an impending correction? 

 

While theoretically possible from a technical perspective: fishing for a top, on the same day that new highs are made, is unlikely ever wise.  Nevertheless, today’s session (12/4) gave us @Fibozachi a very interesting trio of bearish candlesticks for the S&P-500, NDX and DJIA that are each noteworthy. 

 

 

E-mini NASDAQ-100 Futures (NQ)

 

NASDAQ-100 futures (NQ) plotted a large bearish engulfing candlestick; where it’s real body engulfed that of the past two trading sessions.  Because we saw this same candlestick pattern on 11/29, today’s price action confirms that the NDX’ short-term technical outlook is becoming increasingly bearish.  If selling pressure continues, the first short-term downside support speedbump for NQ will be found at 6,200... from there, there is a strong support shelf that spans 6,150 - 6k. 

 

 

 

 

E-mini DJIA Futures (YM)

 

DJIA futures (YM) plotted a shooting star candlestick, meaning:

1. it opened higher than yesterday...


2. traded up to new highs.. and


3. then came back down to close at almost the same exact price as the open.

 

12/4’s YM session also registered as a filled white candlestick; meaning that while YM closed higher than yesterday’s close, that it also closed below yesterday’s open.

When a shooting star candle plots after a strong rally, it is often a warning sign that bullish momentum may be exhausted; the opposite is also true for hollow red candles after a sell-off.

While additional confirmation is required, this is the type of bearish candlestick pattern that may seem obvious in retrospect when looking for signs of a market top.  If selling pressure continues, short-term downside targets are 23,600 with a strong support shelf at 23,200. 

 

 

 

 

E-mini S&P 500 Futures (ES)

 

S&P 500 futures (ES) plotted a bearish engulfing candlestick pattern for the first time in 4 months.  This type of pattern - after such^ a relentless rally - has an increased chance of follow-through ... though in this instance it may just lead to a short-term sentiment reset rather than a legitimate sell-off.  If selling pressure continues, short-term downside targets span 2,550 to 2,600.

 

 

 

 

Volatility Index Futures (VX)

 

VIX futures (VX) plotted a bullish engulfing candlestick pattern for the first time since 8/08/17.  The last daily instance of this pattern triggered a surge that sent $VIX #PriceAction from 16.50 to 19.45 in just 3 sessions.

Today’s instance (12/4) provides additional technical evidence that major US equity ‘markets’ may be topping.  Should VX futures continue to rally... they will likely retest 13.50 before encountering genuinely firm resistance at 14.70 - 15.00.. with extremely strong resistance at 16.50.

 

 

 

Check out Fibozachi.com to learn about modern technical analysis and trading indicators that actually work.

Future’s have Less Selling Pressure than Ever Before… until now?

Dow Jones Megaphone pattern, bounce of new support

Below looks at the Dow Jones Industrials Index over the past 100 years on a monthly closing basis-

In the early 1980’s the Dow used old resistance to become new support at (1), where a breakout and strong rallied followed.

CLICK ON CHART TO ENLARGE

The Dow looks to be using old resistance as new support to push higher off of at (2) again.

Positive price action off new support at (2) continues. For bulls to get concerning long-term concerning message from this pattern, support would need to be taken out at (2).

 

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The Difference Between GAAP And Non-GAAP Q3 EPS For The Dow Jones Was 16%

The last time we looked at the near-record difference between GAAP and non-GAAP Dow Jones earnings, we found that it had crept to a (virtually) unprecedented 25%. To be sure, that was exactly one year ago, when the economy was perceived as being in worse shape than it is now, thanks to the narrative of a "global coordinated recovery" which is really just record central bank liquidity injections, and Chinese credit creation, both of which have recently hit the brakes.

That said, going back to the question of GAAP vs non-GAAP divergence, one would assume that in light of the so-called global recovery of 2017, company earnings would be more real and not the "pro forma, one-time, non-recurring" fabrication that US corporations are so fond of. Alas, one would be wrong.

As Factset"s John Butters writes in a recent blog post, as of today, all of the companies in the Dow Jones Industrial Average (DJIA) have reported actual EPS for Q3 2017, which brings up several questions: what percentage of these companies reported non-GAAP EPS for Q3 2017? What was the average difference and median difference between non-GAAP EPS and GAAP EPS for companies in the DJIA for Q3 2017? How did these differences compare to recent quarters?

Here are the answers:

For Q3 2017, 21 (or 70%) of the 30 companies in the DJIA reported non-GAAP EPS in addition to GAAP EPS for the third quarter. Of these 21 companies, 16 (or 76%) reported non-GAAP EPS that exceeded GAAP EPS. Over the past six quarters (Q1 2016 – Q2 2017) 68% of the companies in the DJIA reported non-GAAP EPS in addition to GAAP EPS and 80% of these companies reported non-GAAP EPS that exceeded GAAP EPS.

Thus, slightly more companies in the DJIA reported non-GAAP EPS in Q3 2017 relative to the average of the past six quarters, while slightly fewer companies in the DJIA reported non-GAAP EPS above GAAP EPS in Q3 2017 relative to the average over the past six quarters.

For Q3 2017, the average difference between non-GAAP EPS and GAAP EPS for all 21 companies was 284.1%, while the median difference between non-GAAP EPS and GAAP EPS for all 21 companies was 10.1%. The average difference between non-GAAP EPS and GAAP EPS for the DJIA was unusually large in the third quarter because of Merck. The company reported non-GAAP EPS of $1.11 and GAAP EPS of -$0.02 for the quarter. Thus, the percentage difference between non-GAAP EPS and GAAP EPS for Merck for Q3 exceeded 5000% (on an absolute basis).

So let"s normalize: excluding Merck, the average difference between non-GAAP EPS and GAAP EPS for the remaining 20 DJIA companies was 15.8%. How does that number look in context: Over the past six quarters, the average difference between non-GAAP EPS and GAAP EPS for companies in the DJIA was 72.8%, while the median difference between non-GAAP EPS and GAAP EPS was 13.4%.

Finally, if one takes the average of the median DJIA median differences for the past 4 quarters (LTM), one gets just over 14% (and 15.8% if "normalizing" the latest quarter"s data).

This means that while the forward non-GAAP P/E multiple may be 18x based on a 33.4 (non-GAAP) S&P EPS, if one assumes that roughly 14% of the latest earnings, and those projected for the next 5 quarters, are "fluff" then applying a 14% haircut to the forward consensus EPS of 143... 

... which amounts to 123 in EPS for the S&P500 - then the market"s forward GAAP PE multiple is 21x. With the exception of the pre-dot com burst, the market"s forward P/E multiple has never been that high.

Washington Is "The New Rome"

Authored by James Rickards via The Daily Reckoning,

I just got back from a trip to Washington, or what I call “New Rome” because Washington’s relationship to the rest of America is the same as Rome’s relations with the agrarian and plebeian citizens of its vast domains in late antiquity.

Washington is a parasite that sucks the rest of the country dry. The counties surrounding Washington, D.C., have the highest per capita income of any metropolitan area in the country including New York, Hollywood and Silicon Valley. The unemployment rate is also the lowest of any large region in the country.

At least New York, Silicon Valley and Hollywood all produce something we need or enjoy. Washington produces red tape, taxes and new ways to handicap innovation on a daily basis.

While America staggers after its first lost decade (2007–17) and with a new lost decade set to begin (Japan, anyone?), Washington grows fat and rich. Trust me, the hotels and restaurants in town are jammed. No depression here.

This is an important observation because it has to do with how great powers decline and fall.

The conventional view of the fall of the Roman Empire is that they succumbed to barbarian invaders. That’s only half the story. In fact, barbarians had invaded for centuries and been repeatedly repulsed by Roman citizens who valued their citizenship and were loyal to the emperor and senate in Rome.

Yet as Rome grew corrupt and decadent, it increased taxes and offered less safety in return. There came a time when barbarian rule looked better to frontier agrarians than rule from the corrupt cosmopolitan center.

When the barbarians invaded for the last time, citizens welcomed them. The barbarian policy was 10% taxes in exchange for order. Rome offered 20% taxation and disorder. Citizens went with the barbarians, and the rest is history.

Rome was not destroyed from the outside; it collapsed from the center. I see something similar happening today.

So why was I in Washington?

Well, for better or worse, this is where critical decisions are made that affect war and peace, decline or prosperity and the success or failure of enterprise. If you want to provide forward-leaning analysis to readers, it’s important to interact both with decision makers and the policy experts who advise them.

I’m always happy to share what I learn with my readers, unless it’s highly sensitive material I can’t divulge for national security reasons.

Here’s the latest readout:

There won’t be any tax cut this year. As we say in New York, “fuggedaboudit.” Maybe next year, but even that’s not clear. The stock market has “priced in” a tax cut four or five times since last November. Wall Street loves a good story. So a tax cut policy failure, similar to the failure to repeal Obamacare, could be catalyst for a 10% stock market correction in coming months.

We’ve had four stock market corrections of 10–15% in each of the past eight years, or one every two years on average. The last one was January 2016, almost two years ago. So we’re due.

A 10% stock market correction is not the end of the world. Still, a quick 2,300-point drop in the Dow Jones industrial average might get some attention. This looks like a good time to decrease your equity exposure and allocate more to cash.

Another potential catalyst to watch for is a possible government shutdown on Dec. 8. That’s the day the congressional authorization to keep the government open expires. Unlike the tax bill and some other issues, you need 60 Senate votes to keep the government running. That means Democrats have to go along.

The issues on which Democrats and Republicans disagree include funding for Trump’s border wall, Planned Parenthood, Obamacare insurance bailouts, sanctuary cities and “Dreamer” immigration status. You get the point. There’s no middle ground.

We’ve had several government shutdowns in the past seven years. Again, this is not the end of the world. But it does not inspire confidence in U.S. governance at a time when China is taking center stage and war drums are beating in North Korea. There’s nothing the stock market likes less than uncertainty. This could be a catalyst for the overdue stock market correction.

Finally, I met with President Trump’s national security adviser, Gen. H. R. McMaster, and CIA director Mike Pompeo Thursday afternoon.

It was a small group, invitation-only gathering. Most of my colleagues wanted to drill down on the Iranian portfolio, but my personal brief was all about North Korea. I’ll let my readers know what I learned in the coming days.

My rule on visits to Washington is not to stay more than two days. I don’t want to be captured by any swamp creatures.

So I’ve addressed some of the potentially negative catalysts coming out of Washington. But of course there are other catalysts from the purely market side…

Bull markets in stocks seem unstoppable right up until the moment they stop. Then comes a rapid crash and burn phase.

Is there any warning besides those I mentioned that a collapse is about to happen?

Of course there is. Analysts warn about it all the time and provide mountains of data and historical evidence to back up their analysis. The problem is that everyone ignores them!

You can talk about the dangers represented by CAPE ratios, margin levels, computerized trading, persistent low volatility, and complacency all you want — which I’ve done — but nothing seems to slow down this bull market.

Yet, there is one thing that can stop a bull market in its tracks, and that’s corporate earnings. The simplest form of stock market valuation is to project earnings, apply a multiple, and voilà, you have a valuation.

Multiples are already near record highs, so there’s not much room for expansion there. The only variable left is projected earnings and that’s where Wall Street analysts are having a field day ramping up stock prices.

Earnings did grow significantly in 2017 on a year-over-year basis, but that’s mainly because earnings were weak in 2016 so the year-over-year growth was relatively easy. Now comes the hard part.

How do you expand earnings again in 2018 when 2017 was such a strong year?

Wall Street just uses a simple extrapolation and says next year will be like this year only better. But there is every reason to doubt that extrapolation. Earnings are likely to fall short of expectations, which can lead to a correction. Once that happens, multiples can shrink as well.

Soon you’re in a full-scale bear market with stock prices down 20% or more. That’s without even considering a war with North Korea and all the dangers others I’ve already mentioned.

This may be your last clear chance to lighten up on listed equity exposure before the bubble bursts.

If you haven’t already, I recommend you move a portion of your portfolio into cash, physical gold and select gold mining stocks, plus other hard assets like real estate and fine art.

Robert Shiller: 1987 Could Happen Again

By Robert Shiller, first published in the NYT

Oct. 19, 1987, was one of the worst days in stock market history. Thirty years later, it would be comforting to believe it couldn’t happen again.

Yet that’s true only in the narrowest sense: Regulatory and technological change has made an exact repeat of that terrible day impossible. We are still at risk, however, because fundamentally, that market crash was a mass stampede set off through viral contagion.

That kind of panic can certainly happen again.

I base this sobering conclusion on my own research. (I won a Nobel Memorial Prize in Economic Sciences in 2013, partly for my work on the market impact of social psychology.) I sent out thousands of questionnaires to investors within four days of the 1987 crash, motivated by the belief that we will never understand such events unless we ask people for the reasons for their actions, and for the thoughts and emotions associated with them.

From this perspective, I believe a rough analogy for that 1987 market collapse can be found in another event — the panic of Aug. 28, 2016, at Los Angeles International Airport, when people believed erroneously that they were in grave danger. False reports of gunfire at the airport — in an era in which shootings in large crowds had already occurred — set some people running for the exits. Once the panic began, others ran, too.

That is essentially what I found to have happened 30 years ago in the stock market. By late in the afternoon of Oct. 19, the momentous nature of that day was already clear: The stock market had fallen more than 20 percent. It was the biggest one-day drop, in percentage terms, in the annals of the modern American market.

I realized at once that this was a once-in-a lifetime research opportunity. So I worked late that night and the next, designing a questionnaire that would reveal investors’ true thinking.

Those were the days before widespread use of the internet, so I relied on paper and ink and old-fashioned snail mail. Within four days, I had mailed out 3,250 questionnaires to a broad range of individual and institutional investors. The response rate was 33 percent, and the survey provided a wealth of information.

My findings focused on psychological data and differed sharply from those of the official explanations embodied in the report of the Brady Commission — the task force set up by President Ronald Reagan and chaired by Nicholas F. Brady, who would go on to become Treasury secretary.

The commission pinned the crash on causes like the high merchandise trade deficit of that era, and on a tax proposal that might have made some corporate takeovers less likely.

The report went on to say that the “initial decline ignited mechanical, price-insensitive selling by a number of institutions employing portfolio insurance strategies and a small number of mutual fund groups reacting to redemptions.”

An avalanche of sell orders exhausted traders in New York. Credit Maria Bastone/Agence France-Presse

The panic in New York spread to the Sydney Stock Exchange in Australia. Credit Fairfax Media

Portfolio insurance, invented in the 1970s by Hayne Leland and Mark Rubinstein, two economists from the University of California, Berkeley, is a phrase we don’t hear much anymore, but it received a lot of the blame for Oct. 19, 1987.

Portfolio insurance was often described as a form of program trading: It would cause the automatic selling of stock futures when prices fell and, indirectly, set off the selling of stocks themselves. That would protect the seller but exacerbate the price decline.

A car for sale after its owner lost money in the 1929 stock market crash.

The Brady Commission found that portfolio insurance accounted for substantial selling on Oct. 19, but the commission could not know how much of this selling would have happened in a different form if portfolio insurance had never been invented.

In fact, portfolio insurance was just a repackaged version of the age-old practice of selling when the market started to fall. With hindsight, it’s clear that it was neither a breakthrough discovery nor the main cause of the decline.

Ultimately, I believe we need to focus on the people who adopted the technology and who really drove prices down, not on the computers.

Portfolio insurance had a major role in another sense, though: A narrative spread before Oct. 19 that it was dangerous, and fear of portfolio insurance may have been more important than the program trading itself.

On Oct. 12, for instance, The Wall Street Journal said portfolio insurance could start a “huge slide in stock prices that feeds on itself” and could “put the market into a tailspin.” And on Saturday, Oct. 17, two days before the crash, The New York Times said portfolio insurance could push “slides into scary falls.” Such stories may have inclined many investors to think that other investors would sell if the market started to head down, encouraging a cascade.

Newspapers grappled with the biggest one-day stock market decline, in percentage terms, in Wall Street’s modern history

In reality, my own survey showed, traditional stop-loss orders actually were reported to have been used by twice as many institutional investors as the more trendy portfolio insurance.

In that survey, I asked respondents to evaluate a list of news articles that appeared in the days before the market collapse, and to add articles that were on their minds on that day.

I asked how important these were to “you personally,” as opposed to “how others thought about them.” What is fascinating about their answers is what was missing from them: Nothing about market fundamentals stood out as a justification for widespread selling or for staying out of the market instead of buying on the dip. (Such purchases would have bolstered share prices.)

Furthermore, individual assessments of news articles bore little relation to whether people bought or sold stocks that day.

Instead, it appears that a powerful narrative of impending market decline was already embedded in many minds. Stock prices had dropped in the preceding week. And on the morning of Oct. 19, a graphic in The Wall Street Journal explicitly compared prices from 1922 through 1929 with those from 1980 through 1987.

A graphic in The Wall Street Journal on the morning of Oct. 19, 1987, compared current stock trends with those of the 1920s

The declines that had already occurred in October 1987 looked a lot like those that had occurred just before the October 1929 stock market crash. That graphic in the leading financial paper, along with an article that accompanied it, raised the thought that today, yes, this very day could be the beginning of the end for the stock market. It was one factor that contributed to a shift in mass psychology. As I’ve said in a previous column, markets move when other investors believe they know what other investors are thinking.

In short, my survey indicated that Oct. 19, 1987, was a climax of disturbing narratives. It became a day of fast reactions amid a mood of extreme crisis in which it seemed that no one knew what was going on and that you had to trust your own gut feelings.

The week of Oct. 19, 1987, people around the country kept a close eye on the market

Given the state of communications then, it is amazing how quickly the panic spread. As my respondents told me on their questionnaires, most people learned of the market plunge through direct word of mouth.

I first heard that the market was plummeting while lecturing to my morning class at Yale. A student in the back of the room was listening to a miniature transistor radio with an earphone, and interrupted me to tell us all about the market.

Right after class, I walked to my broker’s office at Merrill Lynch in downtown New Haven, to assess the mood there. My broker appeared harassed and busy, and had time enough only to say, “Don’t worry!”

He was right for long-term investors: The market began rising later that week, and in retrospect, stock charts show that buy-and-hold investors did splendidly if they stuck to their strategies. But that’s easy to say now.

Like the 2016 airport stampede, the 1987 stock market fall was a panic caused by fear and based on rumors, not on real danger. In 1987, a powerful feedback loop from human to human — not computer to computer — set the market spinning.

Such feedback loops have been well documented in birds, mice, cats and rhesus monkeys. And in 2007 the neuroscientists Andreas Olsson, Katherine I. Nearing and Elizabeth A. Phelps described the neural mechanisms at work when fear spreads from human to human.

The Chicago Stock Exchange was drawn into the market fall

We will have panics but not an exact repeat of Oct. 19, 1997. In one way, the situation has probably gotten worse: Technology has made viral rumor transmission much easier. But there are regulations in place that were intended to forestall another one-day market collapse of such severity.

In response to the 1987 crash and the Brady Commission report, the New York Stock Exchange instituted Rule 80B, a “circuit breaker” that, in its current amended form, shuts down trading for the day if the Standard & Poor’s 500-stock index falls 20 percent from the previous close. That 20 percent threshold is interesting: Regulators settled on a percentage decline just a trifle less than the one that occurred in 1987. That choice may have been an unintentional homage to the power of narratives in that episode.

But 20 percent would still be a big drop. Many people believe that stock prices are already very high — the Dow Jones industrial average crossed 23,000 this week — and if the right kinds of human interactions build in a crescendo, we could have another monumental one-day decline. One-day market drops are not the greatest danger, of course. The bear market that started during the financial crisis in 2007 was a far more consequential downturn, and it took months to wend its way toward a market bottom in March 2009.

That should not be understood as a prediction that the market will have another great fall, however. It is simply an acknowledgment that such events involve the human psyche on a mass scale. We should not be surprised if they occur or even if, for a protracted period, the market remains remarkably calm. We are at risk, but with luck, another perfect storm — like the one that struck on Oct. 19, 1987 — might not happen in the next 30 years.

George Soros Donates $18 Billion To His 'Open Society' Foundation

Hungarian-born billionaire investor George Soros is pledging $18 billion - the bulk of his $26 billion fortune – to his Open Society Foundation, completing the integration of his family office, Soros Fund Management, and the charitable organization that serves as a front for Soros’s globalist agenda.

WSJ reports that the gift has vaulted Open Society to the top ranks of philanthropic organizations. It now appears to be the second largest such organization in the US by assets after the Bill and Melinda Gates Foundation, based on 2014 figures from the National Philanthropic Trust. Soros, who is 87, shares influence over the investment firm’s strategy with Open Society’s investment committee. Soros serves as the committee’s chairman, but the committee was set up to survive him, he said.

“It’s an ongoing process of migration from a hedge fund toward a pool of capital deployed to support a foundation over the long term,” said Bill Ford, a committee member and the chief executive of General Atlantic LLC, a firm that invests in growth-stage companies.

However, Bloomberg reported that the transfer of funds was authorized to help minimize a tax bill hedge fund managers are facing this year. Money managers have until the end of the year to pay taxes on fees they earned from assets in offshore funds, but had earlier deferred payment on. Many are now turning to charitable donations, including to their own foundations, to help offset the tax burden.

Tax experts have estimated that collectively managers have at least $100 billion offshore, based on tax-advisers’ conversations with clients, brokers and fund-service providers. A New York-based money manager such as Soros could be subject to a top federal income tax rate of 39.6%, not including state and local taxes. When Congress eliminated the tax break in 2008 during the aftermath of the financial crisis, it gave hedge fund managers until Dec. 31, 2017 to bring the cash home and pay the accumulated taxes.

It"s believed that most of Soro"s wealth is tied up with his family office. At the end of 2013, Soros had amassed $13.3 billion in his Soros Fund Management through the use of deferrals, according to Irish regulatory filings. Since it"s unclear how much the fund"s assets have grown since then, it"s difficult to tell what percentage of the fund"s assets the donation represents.
 

Soros founded Open Society in 1993 and has used it to support pro-Clinton groups and Super PACs, as well as leftist groups like Black Lives Matter, and other leftist groups that purportedly have links to local Antifa organizations.

Soros has also given more than $33 million to the Black Lives Matter groups involved in the social unrest in Ferguson and Baltimore.

Sources close to Soros told WSJ that he doesn’t plan to trade the billions that now belong to Open Society. After stepping back from active management in 2000, Soros came out of retirement in 2007 to bet against the housing market, and has had several notable trading successes in recent years – including a profitable bet on S&P 500 puts ahead of the June 2016 Brexit vote. His most recent trade was a bet that stocks would slump following Trump’s election.

Instead, the Dow Jones Industrial Average climbed above 23,000 for the first time on Tuesday.

Several states have accused Soros of inappropriately meddling in local affairs. Israel accused the philanthropist billionaire of "continuously undermining Israel"s democratically elected governments.” Meanwhile, Soros’s support for refugees brought him into conflict with Hungarian President Viktor Orban, formerly a friend of the billionaire. Orban has accused Soros of being a political puppet master, and officials in his government have described Soros’s Open Society charities as “political activism disguised as NGO work.":

Soros, who has lived under both communism and Nazi occupation in Hungary, hoped to foster “open societies” in places where authoritarian governments held power. He named his foundation after a book by the philosopher Karl Popper, one of his teachers at the London School of Economics, who was a notable defender of liberal democracies.

As WSJ explains, Open Society operates through a network of more than 40 foundations and offices in countries from Afghanistan to South Africa and has a broad mandate to act on its founder’s values. OS organizations have funded refugee relief, public-health efforts and programs including a mobile court for gender crimes in the Democratic Republic of the Congo. The philanthropy also advocates for rights of the Roma, one of Europe’s largest ethnic minorities.

Responding to rumors that the firm is becoming more risk averse, one of Soros’s portfolio managers told WSJ that the firm would still look for opportunities for profitable macro trades, but that those opportunities would be smaller and more fleeting.

Though Soros has been a vocal opponent of President Donald Trump’s agenda, he once hired Treasury Secretary Steven Mnuchin to run a credit business at Soros.

It’s long been known that most of Soros’s fortune would eventually go to Open Society, though Soros previously funded it with annual donations. He plans to give it most of the rest of his wealth in his lifetime or upon his death, said people familiar with the matter, pushing its assets above $20 billion.

Soros Fund Management’s annual returns have averaged around 11% in the past 10 years, according to a person familiar with the figures, well below the 30% of its early decades.

Soros has about $6 billion in private-equity and related investments, including African cellphone towers and a stake in a restaurant chain called Dinosaur Bar-B-Que. The overseers of this chunk of money report to Open Society’s investment committee.

Soros is best known for building one of the world’s largest fortunes through a series of super-profitable trades. In September 1992, the Bank of England left the European Exchange Rate Mechanism under pressure from speculators, including Soros, who had been aggressively shorting the pound.

The trade netted Soros a profit of $1 billion and earned him a reputation as the man who broke the Bank of England. 

Dow Hits 23,000 - There's Just One Thing

Just four weeks since The Dow crossed 22,000...but thanks to Goldman, Boeing, Caterpillar, 3M, and JPMorgan (accounting for over 500 Dow points), the mainstream media"s favorite index just topped 23,000 for the first time ever...

With the Top 6 names driving 50% of the index"s move...

However, it seems options traders ain"t buying it...

If everything"s so awesome... why are investors buying Dow protection with both hands and feet?

As retail piles in, so professoinals are hedging to extremes.

Finally - for good measure - "Industrial" Production remains well below 2014 highs... but the "Industrial" Average is soaring...