Weekly Economic Update 01-12-2018

China Just Weaponized Our Debt

China, the largest holder and purchaser of U.S. Treasuries, announced Wednesday that they are considering reducing or ceasing the purchase of our debt going forward. This move was in response to the recently passed tax reform bill, that China said, if passed, there would be repercussions. In addition, China announced they would be purchasing nearly 200 new Airbus airliners instead of buying from Boeing, indicating China has other options in a global economy.

The timing of China’s announcement couldn’t be more perfect with Congress set to tackle the budget next week. With domestic debt levels at record highs across the government, states, municipalities, corporations, and consumers, the message from China was a warning shot across the bow that we need to get our fiscal house in order. Given we are the biggest debtor-nation in the world, it was only a matter of time before this happened.

The initial reaction to China’s announcement caused bond yields to rise, while experts suggested the thirty-five year, bond-bull market bond-bull market is over, but that is a false move. Wednesday’s 10-year Treasury auction saw strong foreign demand, which quickly brought yields back down, but that doesn’t mean we should ignore China’s warning. The real issue is with short-term interest rates and how they will affect our overly indebted society. The risk is high, with most investors at near 100% allocations to stocks and volatility at historically low levels, we are a liquidation away from a market meltdown.

China is upset with the perception of abuse by the United States as being the reserve currency, which allows us the ability to print an endless amount of money in exchange for tangible foreign goods. When we want to buy something, we print dollars and then use them to purchase foreign goods. As those dollars build up in foreign banks, they lead to inflation, which is how we export inflation. To damper inflation, foreign central banks take some of those dollars to buy U.S. Treasuries. As those dollars return to the United States to buy debt, the dollars are removed from the money supply. It’s quite a brilliant system that has allowed us to run perpetual deficits, export inflation and exchange paper for tangible goods.

Furthermore, the United States is in the process of restricting the money supply to rein in all the money we printed to bail out our economy from the Great Financial Crisis. Since China, and other foreign countries, need dollars to conduct business internationally, as we remove dollars from the system, it raises their cost of doing business. On top of that, we are increasing our deficits from the recent tax reform plan that will require more U.S. Treasuries to be bought with a shrinking supply of dollars. With fewer dollars in the global system, global growth is constricted.

The fact that this is happening should not surprise anyone. President Trump, in his former occupation, pointed out that if you owe the bank enough money, you own the bank. In this case, we owe China several trillion dollars, meaning as they feel more confident, they will start to call the shots. Not surprisingly, the Trump administration immediately backed off some of its proposed Iranian sanctions after China’s announcement. Any threat to the existing monetary system is a threat to the American way of life.

Without the ability to “sterilize” dollars through the existing system, the American public will have to start buying our own debt This means a 1970’s-style inflation would make its way back to our country. While Americans seem to champion inflation, they should be careful about what they wish for regarding money. As I may have previously mentioned, last year the International Monetary Fund (IMF) stated in a report that if interest rates in America were to rise, 22% of all American corporations would fail due to their inability to service their debt. That means the stock prices in those companies would go to zero. That’s not a situation we want to be in, especially with everyone currently crowded into stocks and short volatility.

The heart of the matter is that our fiscal house is a mess. The Congressional Budget Office estimates that the United States needs $50 trillion to cover the unfunded liabilities for Social Security and Medicare. Experts suggest that the CBO is wrong and that the real number is between $100-200 trillion – which additionally factors in all the unfunded pension liabilities. The concern is the United States will continue to recklessly print money to pay bills. That will devalue the money our foreign trading partners hold, which will lead to higher commodity prices.

If you are China and you are trying to bring your country into the modern age, the one thing you want is a stable currency and low commodity prices – something the current system doesn’t provide. That is why China has aggressively sought trading relationships in their native currency, the Yuan, and is close to allowing those who sell oil to China to convert their Yuan to gold. All of this is being done to circumvent the U.S. dollar and put China in a position to be the next global superpower.

Wednesday morning Bloomberg broke the news that China would “slow purchases” of U.S. Treasuries and that news flew around the world at lightspeed. The stock market and bond market reacted as speculators rushed to adjust their positions. Major news outlets covered the story. Financial bloggers posted their opinions. Twitter went wild as experts weighed on their opinions and it’s all the money talk-show hosts talked about today. Even I rushed to pen this article for you!

Wednesday evening, shortly after the Chinese stock market opened, Bloomberg reported that this was fake news. The Chinese State Administration of Foreign Exchange (SAFE) stated that their “investment in Treasuries is based on market conditions and its needs.” On that news, Treasury yields fell back below their pre-Bloomberg-fake-news level.

Maybe this report is entirely fake or maybe China wanted to test the markets to see how the world reacted. As it turns out, the world takes them very seriously and the United States should use this as a wake-up call and consider what could come if other countries choose to stop buying our debt. If there’s one thing we can all take away from this, is that news, whether fact or fake, has the power to disrupt markets.

Video Topic of the Week – Redux of 1929

Last year I mentioned we are headed down the same path that lead to a Great Depression. With short-term interest rates rising and money flooding into stocks, I thought it would be a good time to revisit that topic. The similarities are frightening!

Chart of the Week – Real S&P 500 Index Corrections from Peak Valuations

This week we will look at how far markets normally correct based on the Shiller Cyclically Adjusted P/E ratio and the S&P 500 adjusted for inflation. If this chart is correct, stock prices could fall to where they were in the late 1990’s.

Portfolio Shield™ Update

The January Morningstar® Investment Detail Report is now available and is linked below in this e-mail.

2018 Opportunities

I find the psychology of investor behavior rather fascinating. When asset prices rise, people start to believe that prices will rise indefinitely and that if they don’t get in, that they will miss out on infinite gains. Yet everyone knows that every asset bubble comes to an end – there’s never been an asset bubble in the history of the world that has perpetually risen.

When it comes to bubbles, everyone also thinks they can get out before the peak, but that rarely happens. Few survived the dot-com bubble or the mortgage bubble, and few will survive this one.

Yet for some reason, we are conditioned that the only way to profit from an asset bubble is to participate. As the mortgage bubble collapsed, a few with the foresight to short mortgage bonds came out ahead. Stock markets move in two directions and there are ways to participate in both.

Qualified plans only allow people to participate in the upside of markets and most financial advisors invest in the same fashion. However, I can participate in both directions, meaning once this market peaks, we have the opportunity to profit on the downside – in addition to my interest in gold and silver.

I recently consulted a few people to learn how they approach the downside of the markets. The first is a renowned short seller who’s name sparks fear in the hearts of CEO’s that find out he is coming for them. He prefers to wait until the big money has sold out their positions in a company that he’s targeting before entering his short positions. As a true master of investor psychology, he waits until the public starts selling before placing his trades. After all, the public buys most at the top and sells the most at the bottom.

The second person I consulted is a global macro investor. His advice was to wait until the ISM PMI falls below 50. His view is that when the factory data starts to contract, that that the economy is going to contract and that is a safer way to approach the downside of the market.

The last person I consulted is someone who worked on the trading desk of a large hedge fund. Upon his departure, he took with him all his notes and strategies for how the hedge fund approached shorting. While he wouldn’t give me any specific advice, he did say he would let me know when he was going to enter his short positions. He did say that the signals he looks for when shorting the market are the exact opposite of what he looks for in a market bottom.

Based on my own research, I found that one of the best ways to identify long-term trend changes is in the consumer confidence data. When consumers start to turn pessimistic about their future, the stock market soon follows. Once consumer confidence begins a steep dive, as I showed in the chart pack a couple weeks ago, stocks fall, and bonds rise. For that reason, I have added consumer confidence into the monthly chart data as it comes available.

Along those lines, I am testing a modified version (an inverted version) of the Portfolio Shield™ algorithm that uses inverse funds to take advantage of the next market downturn. I tried this once early on with mixed results, but I now know why it didn’t work before. With the long weekend ahead, I plan to spend my time working on this.

As I mentioned, the risk with late stage bull markets is that nobody knows when they are going to end. Based on all my research and understanding of what is driving the markets, my fear with this market is that when it starts to fall that it could quickly become illiquid and stocks prices could plummet. Because I don’t want to see my clients wiped out if liquidity dries up, which would make it impossible to sell, the less risky approach is to let the markets peak and then feast on all those who were greedy enough to buy stocks at these absurd valuations. Based on trading volume and reports from different custodians, the recent buying activity is mostly retail investors. And as I mentioned, they are always the last buyer in every market, meaning our opportunities are coming soon!

Weekly Broad Market / Economy Commentary

In what should be considered a surprise move, the Bank of Japan has reduced the number of bonds it is purchasing. Also starting this month, the European Central Bank is expected to halve its bond purchases. Based on the weekly balance sheet report, the Federal Reserve appears to be increasing the number of Treasuries they are selling. While the initial reaction by the markets was to push up interest rates, investors should understand that any reduction to the money supply or rate of growth of the money supply implies that demand for long-term projects should fall, along with long-term bond yields.

Yet speculators often referred to as the “smart money,” have increased their short positions on 10-year Treasuries, which is artificially pushing yields up. The general narrative is that inflation is coming in a big way and this is validated by how market participants are positioned. Speculators are most likely trying to profit from the public’s belief that inflation is coming, and it’s working. However, as the money supply continues to fall, the velocity of money remains at depressed levels, import prices fall, and producer prices fall, the notion that the Consumer Price Index is going to jump is unlikely.

What people forget about bonds is that when the stock market reaches a certain level, money managers begin to shift their allocation to bonds. This has happened during every bubble, with bond yields falling to new all-time lows with each successive recession. With everyone piled into stocks, it’s hard to believe this time will be any different.

The stock market is likely in the euphoria stage where higher prices beget higher prices. Valuations and fundamentals are being ignored as investors continue to buy. Former hedge fund trader Jesse Felder noted this week that the Warren Buffet indicator, which is stock market cap / GDP, has exceeded its 2000 high and 28 stocks are now trading at ten times revenue, compared to 29 stocks that traded ten times revenue back at the peak of 2000. What ‘ten times revenue’ means is that a company has to pay 100% of revenues for ten years straight in dividends for an investor to get their money back. That also assumes that the company has zero expenses, unlikely, pays zero taxes, also unlikely and the investor pays zero taxes on their dividend payment, again, unlikely. Oh, and it means zero R&D for the next ten years as well. If there’s any doubt in your mind about how overvalued some of these stocks are, that should be a strong indication that most investors will not get their money back for a very long time.

Analysts have suggested that the recent corporate tax cuts should add 10% to earnings, however, the stock market has already priced in earnings exceeding 20%. Investors once cited dividends as their reason to buy stocks, but now the 5- 10- and 30-year Treasury yields are higher than the dividend yield of the S&P 500. A mark of a speculative market. Based on Dr. John Hussman, an institutional money manager, the expected 12-year return of the stock market is now negative.

What this means is that the stock market is not cheap. Prices are high, but that hasn’t stopped people from buying. If it sounds just like the mortgage bubble of 2008-09, it is, except it’s in stocks. What surprises me is that nobody is warning their clients of excess valuations. That’s the challenge with this industry – clients want their advisors to take the risk to keep up with the market, but avoid any downturns. You can’t have both.

Something to keep in mind – 50% of all trades are being front-run by High Frequency Traders and 20% of trades are submitted by autonomous Artificial Intelligence programmed computers. Everyone is trying to figure out what the trigger point for these devices to turn bearish. But be aware, when they do, the market may fall very fast. Even the Fed has mentioned that they are concerned about what these algorithmic trading devices could do to the market. That is something we’ve never had to deal with before!