I FORGOT WHAT WE ARE DEALING WITH

2017-02-22 7pm EDT  |  #stocks #Fed balance sheet #Trump

The other day I wrote a piece highlighting the dangers about Trump’s over promising regarding the upcoming tax cuts. I argued the best CEOs underpromise and overdeliver - the exact opposite of what Trump was doing.

One of my astute readers pointed out that Trump’s rhetoric could not be examined in a vacuum. Unlike the CEO, Trump’s comments have a reflexive nature. By expressing optimism, Trump can actually effect the public’s behaviour.

I have been thinking about this phenomenon as I read all the research pieces about how the market has gotten way out ahead of expectations. Even though there seems to be every reason in the world for the stock market rally to pause, it keeps chugging higher.

There are plenty of smart guys calling for a realigning of prices and realistic expectations. Included amongst them is Goldman Sachs (from CNBC):

“Financial market reconciliation lies ahead,” said David Kostin, Goldman’s chief U.S. equity strategist. “We are approaching the point of maximum optimism and the S&P 500 will give back recent gains as investors embrace the reality that tax reform is likely to provide a smaller, later tail wind to corporate earnings than originally expected.”

Kostin sees a dichotomy between investor hopes and the reality on the ground, and says it’s indicative of “cognitive dissonance” in the market.

“On the one hand, investors, corporate managers, and macroeconomic survey data suggest an increase in optimism about future economic growth,” he said. “In contrast, sell-side analysts have cut consensus [full-year] adjusted [earnings per share] forecasts by 1 percent since the election and ‘hard’ macroeconomic data show only modest improvement.”

Investors have pinned their hopes to Trump’s plans to cut taxes, reduce regulations and increase domestic government spending. However, Kostin thinks tax reform probably won’t get done until the back half of the year.

As that reality sets in, the market will have to reduce its expectations for the effect that lower taxes will have on corporate earnings.

This line of thinking roughly mirrors my concerns about Trump boosting the stock market to levels bound to disappoint.

History is also on the side of this scenario playing out. I stumbled upon this terrific chart from Nautilus Investment Research which highlights the stock market behaviour in the months following inauguration.

Most Presidents with a positive first month did not follow up with a second month in the black.

Given the extended nature of the current stock market rally, it is easy to say we are due for a pause and be cautious about the near term outlook.

Yesterday as I had a conversation with another sharp reader, he concluded our email exchange with a “who knows? Maybe it just ends in an epic melt up.”

And he reminded me of the argument I have been making throughout the years (“The World’s Biggest Short Squeeze” or “Peak Insanity”), but seemed to have forgotten during the past few weeks.

Since the 2008 credit crisis, the world’s Central Banks have pumped an extraordinary amount of liquidity into the financial system. In what can be construed as one of the greatest monetary experiments of all time, the amount of stimulus has been unprecedented. Whether it is the Federal Reserve, the ECB, the BoJ or the SNB, Central Bankers have partied harder than a sophomore on spring break in Cancun.

By now we all know the story. All that monetary stimulus in essence just lay fallow as the velocity of money plummeted, offsetting the Central Bank stimulus.

The Central Banks ended up pushing on a string, unable to create inflation, and in the process exacerbating all sorts of inequality problems as financial assets soared higher.

But what if that monetary fuel has finally been lit? What if the seemingly perpetual trend of declining velocity has finally stopped?

If somebody tells you they know how markets will react to a reversal of the decline in the velocity of money, you should probably ignore them. If they tell you that the trend is lower and that demographics, technology or some other excuse will never allow the velocity of money to reverse, tell them to have a look at the period from 2002-2006. Velocity rose within a secular down trend.

Now imagine an increase in the velocity with the massive Fed balance sheet. Or even worse, imagine what will happen if Japan or Europe finally ignites.

No one knows what will happen. During the 1980s the value of the land under the Emperor’s Palace in Tokyo was worth more than the entire state of California. This was the sort of bat shit crazy stuff that can happen when monetary policy goes awry.

Well today we have Central Banks pegging rates at negative levels while they are aggressively expanding their balance sheet. This makes the previous monetary mistakes look like child’s play.

Everyone is assuming the growing inequality problem will be corrected with a massive financial markets crash. But what if instead the opposite happens? What if instead of stocks and homes being halved, they double from here? Or triple or quadruple?

I am not predicting this outcome, but I am willing to entertain the idea. Soros is famous for saying that when he sees a bubble, he buys it. Well, you could argue this is the biggest bubble of all time. And although it might be about to end in a flaming wreck next week, what if the truly manic part is still ahead of us?

Often the last 50% of the move in price occurs in the final inning. Have a look at gold in the 1970s.

It took five years for gold to go from $200 to $400, but $400 to $800 took less than a year.

Although stocks are stupidly overbought, the fact that everyone still thinks they are insanely expensive, leads me to wonder if the real pain trade is higher, not lower.

I have argued in the past that a stock market melt up is just as likely as a melt down. I still contend the next crash will occur when the Central Banks lose control of the bond market. It will not emanate from stocks because the true distortions are in fixed income, not equities.

I have been focusing too much on the short term ticks, not stepping back and thinking about the big picture. I am not suggesting that you run out and buy stocks up here. They are indeed scary. But they are probably just as scary on the upside as they are on the downside.

Thanks for reading,
Kevin Muir
the MacroTourist