Market Sharks & Debt Traps

Written by Dennis Slothower
Posted October 7, 2017

Tax Reform Hope Persists

The stock market continued to push through all-time highs through Thursday over growing optimism of a tax reform bill. It took weak data on Friday to buck the trend, if just slightly. The U.S. House of Representatives voted to adopt a fiscal 2018 spending blueprint containing a legislative tool that would let Republicans bypass Democrats and pass a bill by a simple majority in the Senate, where they hold 52 of 100 seats.

The bulls rallied on the news of the perceived odds of passing a tax reform bill improving after this legislation. With Republican Senators like McCain, Corker, Collins, Murkowski, and other Republicans in name only, whose aim is to submarine the president’s tax bill like they did the repeal of Obamacare, the odds really haven’t improved, but this news is a great call to get people to buy into riskier assets.

First-quarter earnings grew 14% for the S&P 500. Now forecasts are for a 4% growth rate, which hardly justifies stocks to continue growing at a more manic pace.

Greedy Bulls?

The bull market continues under:

  1. The belief that liquidity is still being provided by central banks (ECB and BOJ), though the Fed is shifting to a tightening phase.
  2. Even if the Fed raises interest rates in December, rates are still very low, causing investors to seek out stocks.
  3. Why sell if stocks are making new highs?
  4. An even chance that the GOP will succeed in passing a tax reform bill.

There is no denying we have a bull market. I just find that when we see “extreme greed” conditions, it is an invitation for investment bank dumping sooner or later.

71005-extreme-greed

This is no time to be speculating and ignoring extreme overvaluations just when the Fed is planning on taking the punch bowl away. Gambling on a tax cut that may or may not happen is not an investment strategy.

It is a mistake to think that just because interest rates are low, the yield curve can’t invert with another rate hike. This is where short-term rates are equal to or greater than long-term interest rates. And when this happens, recessions follow.

Look at how far above the three-year standard deviation the S&P 500 has become!

71005-SP500-3yrStdDev

This chart is like a sign you might see on the beach warning surfers of the dangers of a “high risk” riptide zone.

The significant point is that in the dot-com era, the S&P 500 never breached above two standard deviations of the three-year moving average, and it did it only briefly in 2007.

Yet, in early 2017, the S&P 500 broke above the two standard deviations on the expectations of the repeal of Obamacare and tax reforms and is now at one of the widest points from this same standard deviation from the three-year moving average. This extreme deviation invites a reversion back to its mean — especially if there are not enough votes in November to pass this tax reform bill.

Ignoring Risk

 

People forget just what the downside risk represents for the S&P 500 index on the next contraction.

71005-recessions

This chart suggests the S&P 500 index has the potential to go down to 1,077 if the Fed normalizes interest rates at 3%. This represents a $10 trillion loss. It’s a very real risk given the historic amount of capital on leverage — far beyond the peaks of 2000 or late 2007 economic cycles.

Mayor Vaughn: I’m only trying to say that Amity is a summer town. We need summer dollars. Now, if the people can’t swim here, they’ll be glad to swim at the beaches of Cape Cod, the Hamptons, Long Island…

Brody: That doesn’t mean we have to serve them up as smorgasbord!

Jaws (1975)

The sharks are there if you’re paying attention.

Debt Trap

The Bank of International Settlements (BIS), i.e., the central bank of central bankers, worries that central banks are in danger of falling into a debt trap where they can’t take the “needed” action for fear of triggering defaults and economic turmoil.

BIS stresses that central banks need to be less focused on inflation and more on financial stability. Low interest rates are encouraging record amounts of borrowing — as is the asset-buying stimulus employed by many central banks to lift inflation.

However, this kind of policy is making central banks nervous about raising interest rates if it causes a slump in their economy, known as a “debt trap.” It’s a damned if you do, damned if you don’t situation because you’re creating a historical bubble of massive debt and speculation that undercuts banks’ long-term financial stability.

BIS seems to be advocating for higher interest rates even if it means inflation is underachieving its 2% goal to curb explosive debt growth exposure. My guess is Janet Yellen and her fellow governors will likely express this line of thinking going forward for quite some time.

71003-global-debt

The truth is global debt is growing much faster than the world’s GDP, and that means if the central banks do not curb this debt growth, the world’s governments will soon default.

We look to be heading for an avalanche of bankruptcies and defaults, as we are beginning to see now with many retailers.

The stock market is showing extremely abnormal behavior, with the Fed/investment banks suppressing selling and sucking in the greedy and gullible Republicans betting on a tax cut.

Goldman knows exactly how to pump the tax cuts, but I would be very wary of the politicians. The odds are very low, with several Senators looking to submarine it.

To your wealth,

Dennis Slothower Signature

Dennis Slothower
Editor, Wall Street Underground Profits

Dennis Slothower has been leading a small but profitable group of investors to some extraordinary profits in both good markets and bad over the course of a 38+ year investment career, starting as a stock broker in 1979. In 2011 Dennis was named the top performer by Hulbert Financial Digest for avoiding the Crash of 2008. Now, he is bringing his extensive experience to the public through Outsider Club and Wall Street Underground Profits. For more about Dennis, check out his editor page.

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