Sword Of Damocles: Unintended Consequences Of Federal Tax Reform And Monetary Policy

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by: Mad Genius Economics

Summary

Fed Forcing Removal of Liquidity.

Real Issue: Solvency.

Tax Bill Less Bang for the Buck.

Gold Set to Shine.

The big economic events that just took place were the passage of the Trump tax cut, the rate hike of 0.25% by the Fed with projections to make three more next year, and the ramping up of balance sheet reduction at the Fed. All will have either a dramatic new impact or will add dramatically to prior actions. On the one hand, we have added liquidity into our economy, and on the other hand we have reduced liquidity. It’s like a game of tug of war where both sides are have Americans pulling, and in the middle the loser falls into a pit of fire. Like the Sword of Damocles, there is imminent danger here that is clouded by other circumstances, obscuring our view of the real dangers at hand. And it is being further complicated by the ECB and BoE tightening actions as well.

I hope this blog posting will continue to challenge your notions of the Trump bump, employment, GDP growth (R&D is now part of investment in GDP calculations, even though businesses expense it), asset appreciation... the whole economy. You’ve probably heard in the financial media about the everything bubble and small corrections being overdue and other such notions. Those ideas are the understatement of the century, and what I fear is coming I think will make The Great Depression, Weimar Germany, Argentina, Zimbabwe, and Hungary combined look like child’s play.

Before I get into my comments, I want to take a moment to thank Bruce Hurwitz of Hurwitz Strategic Staffing. I was featured in his podcast on December 26, 2017, and we spoke about the Fed. A little history, the Fed’s role, the power of speech at the Fed, interest rates and other monetary policy tools, and more. To listen please click here. I’ll be grateful and I am sure Bruce will be grateful too. I must also thank my high school classmate, Professor Cox, for helping me sort out some of the provisions in the tax bill and organize my thoughts. Conversations with her were instrumental to that process.

2008

If we look back at the financial crisis a decade ago, the basic story line is that banks wildly lent to unworthy borrowers, their adjustable mortgage rates started moving up, they defaulted, and this all caused a break down in the entire banking system leading to widespread defaults and economic collapse.

In swoops the Fed and Treasury to the rescue, first with $787 billion, then QE1, QE2, Operation twist, and many desperate measures in an attempt to support an ailing economy with heavy doses of liquidity.

Unfortunately for Wall St., Main St., and everyone else in between, the problem was not liquidity. Therefore, injecting liquidity was not the right solution. It was like seeing a patient with the recurring heartburn caused by h-pylori, but instead of giving the LAC Antibiotic regimen and some pepto to the infected patient, the doctor gives water and Alka Seltzer, and wishes the patient luck. It’s sorta the right thing and may help for a while, but in the end the patient is still sick with the virus.

The real problem in 2008 was not liquidity. Rather, it was solvency. Banks became insolvent. Let’s use fictitious bank names to illustrate the point, instead of poking fun of landmarks like “Bailout Ballpark” here in NYC (That’s where the Mets play, and yes, I am a fan of their arch rival).

Bank A makes a contract with Bank B to sell short Investment I. Bank B then says, “We like the idea, and since we are already long on Investment I, it makes sense to hedge that by going short on the same investment, just in case.” So Bank B goes to Bank C and makes a new contract to go short on Investment I with Bank C. Bank C then turns around and says “Hey wait a sec, our position in Investment II looks like it could be a risk as well, so let’s go to Bank D and make a contract to short Investment II.” And so on and so forth.

It’s really not as complicated as I make it sound. All of these positions were done on margin (borrowed cash), and the banks all netted out their long and short positions. By netting everything to zero, they thought they were safe. But there’s a really big BUT here. The problem was two-fold. First, no one knew anyone else’s positions, so rather than measuring net at risk, the banks should have measured gross at risk.

The second problem compounds the first and causes the over riding issue at hand, which again was solvency, not liquidity. That problem was the margin debt that was used to stake out positions in all these investments. Leverage of putting down $1 cash for every $100 or more in a position. If Bank A had $1000 in assets bought with $10 cash plus leverage, and therefore if they had $990 of liabilities, a loss of value of just 1% in the asset value renders Bank A insolvent. As long as the asset continues to rise in value, there is no problem. But G-d forbid it falls and the banks are forced to recognize the market value of the asset rather than the par value price at the point of purchase, and we have a system wide crisis of insolvency.

Like the heartburn patient in the analogy, the problem was not properly addressed. The liquidity that was injected only helped so much. And now everyone thinks that if the same thing happens all we have to do is inject more liquidity. It’s not so simple and that’s the wrong solution.

I’m sorry to tell you that not only did the wrong course of action prevent a proper cure the first time, it will prevent it again, and the problem is actually worse now. The reason it is worse is that the financial system is much larger now than it was in 2008. As the scale of a complex system grows linearly, the risks to the system grow exponentially…scale up by 100% and the risk more than doubles, perhaps to 3x, 4x, or 10x. It’s a fundamental principal of Bayesian theory of complexity, but it must be applied to our financial system instead of physics or chemistry. The scale of the financial system is now much larger than 2008, over $70 trillion of debt larger, in fact.

The fundamental issue at hand is not liquidity, it is solvency. However, liquidity will be blamed, and it will cause a cascading snow ball effect that will expose the financial system’s problem of solvency for what it is. It will go all the way up to the highest echelons: CEOs of the biggest banks in the world as well as central banks including our own Fed, the ECB, BoE, BoJ, and others. Make no mistake, the bankers of the world are likely to give the wrong diagnosis and the wrong cure, and we’ll see much more than we saw in the aftermath of the last crisis. We may see much more QE than ever contrived, helicopter cash, universal basic income, negative interest rates, bail ins, bail outs, and much more.

It’s important to remember what Mike Maloney says, that “on the opposite side of every crisis lies and opportunity.” Our job is to see the crisis coming long before hand, and find the opportunities that await us before, during, and after the crisis. Wealth will be transferred, and the question is if you will let it pass you by, will the wealth be transferred out of your hands, or will it be transferred into your hands. If you position yourself correctly, you can build and protect long-lasting, generational wealth.

None of the experts or leaders or talking heads knew what was coming. I’m guessing most of you still don’t really know what happened…But there were some who saw it coming. While the whole world was having a big old party, a few outsiders and weirdos saw what no one else could…the giant lie at the heart of the economy. And they saw it by doing something the rest of the suckers never thought to do. They looked. [emphasis added] -The Big Short (movie)

The Fed

A lot is going on at the Fed these days…New chairman, rate hikes, balance sheet reductions, and more. Let’s start with the new chairman, Jerome Powell, keeping in mind that Trump picked him to succeed Janet Yellen in February 2018. There’s a lot of talk about Powell not being a PhD economist, and instead he is a markets guy. That sounds great and it’s a welcome change. In fact, the Fed has seen much better people at the helm who were bankers and businessmen with real world experience, in contrast with the academics we’ve had in the chairman’s seat more recently.

But for all the talk, Powell will probably follow in the footsteps of Janet Yellen. He has made numerous public statements indicating as such. At least in the first 6-12 months he’ll likely not deviate from Yellen’s plan of rate hikes, especially since the infamous dot-plot is telling the Fed to make 3 more hikes in 2018. He has also indicated that the planned balance sheet reduction may be too much. At first it seems contradictory to keeping Yellen’s rate hike schedule. Upon further examination we may conclude that not only will he be likely to slow the pace and the amount of reductions to the Fed balance sheet, but he is also ready to lower interest rates again at the first sign of trouble. For now, though, it will be steady as she goes.

Raising Rates – We just saw a quarter point hike, and we are likely to see 3 more next year, according to the Fed itself. Anyone with a variable rate debt or anyone taking on new debt will have higher payments with each rate hike at the Fed, translating into less discretionary spending money. Less for savings. Less for anything and everything, and even though there are some preliminary reports to the contrary I think this holiday season will be worse than expected. If it’s not the holiday season itself, it will be in the first quarter next year when the holiday spending bill comes due to everyone who bought their holiday cheer on credit cards. And yes, I know MasterCard (MA) reported record transactions. Remember though that we now live in a world of Amazon and other online retail stores. Internet shopping may be growing, but let’s wait and see how much total shopping is done this holiday season.

Along with consumers being squeezed, businesses with variable rate loans or who are getting ready to take on new debt are seeing higher rates, translating into less cash on hand for expanding the business, making new capital investments, hiring more employees, and anything else they might do with capital. Like a slow leak in the backyard swimming pool, their cash is slowly being diverted to debt service instead of conducting business. The recent announcement by 14 companies that they are giving extra bonuses because of the tax plan likely will turn into a one-time bonus by CEO’s who want to move the public narrative towards favoring tax cuts. I doubt we’ll see permanent pay raises.

Quantitative Tightening – Currently, this is the sale of treasuries and mortgage backed securities as well as not rolling over treasuries, though in the future it may include other measures. Trimming the Fed balance sheet will make a double whammy in conjunction with rate hikes because it puts further upward pressure on rates. As the Fed sells treasuries and MBS’s, there won’t be enough buyers to soak up the additional supply being added back into markets. And that’s in addition to any new treasuries that Treasury will be selling.

It’s a massive opening of the flood gates that will overwhelm demand in the markets for these securities, and as long as there is selling pressure to bring the price down, there will be an opposing pressure to bring rates up naturally through market forces. It was only $7 billion in the first month, but by October 2018 this will be in full swing to the tune of over $50 billion per month, and the cumulative total will be over $1.25 trillion by the end of 2019.

Other Central Banks are now doing the same as well. The Bank of England (BOE) recently raised their rates by 25 basis points, and the ECB is tapering its own QE program which should be grinding to a complete halt also by the fall, 2018. It makes two more central banks that are removing liquidity both directly (ECB) through tapering its purchases and indirectly (BOE) by raising rates and making it more difficult to pay debts and diverting more cash towards those debts.

Yield Curve – The spread we are interested in is the spread between the interest rates at the ten-year treasury versus the two-year treasury. We want to see a spread of around 250-300 basis points (2.5-3% difference) in a healthy economic environment. If the curve tightens, or flattens, it can be caused by a reduction in the long term rate, an increase in the short term rate, or both. And it could be either in real terms or relative to each other as well.

Flattening indicates either concerns for the macro-economic picture, or it indicates rising stress in the banking system. Stress for banks because banks want to borrow at the shorter term rates but then lend out at the longer term rates. If the spread is too close there is too much risk and banks don’t want to take on that risk in exchange for the minimal return they’ll earn on the loans. If the spread inverts so that short term rates are higher than long term rates, banks will completely close their lending facilities until further notice. And make no mistake, inversion of the yield curve has never failed to precede an official recession by about 12 months or so.

As of this writing the yield curve is now hovering in the 50-55 bps range, and it implies that the Fed has just two rate hikes to go at 25 bps each, before it intentionally flattens or inverts the spread in the yield curve.

Because of the flattening there is no longer any profit in prime lending to borrowers with full documentation of income, assets, and employment. Banks have already loosened their lending standards for primary residence mortgages. Remember those 100%+ LTV loans, NINJA loans, option ARM loans? They’re slowly coming back. And subprime lending as well as riskier credit, such as revolving balances, are the only place left that banks can earn profits in their core business.

Even though the riskier loans are where the profit is located now, these loans are becoming increasingly difficult for borrowers to obtain. Outside of the proper context it doesn’t make sense that a business with cash flow should have difficulty borrowing. But I have spoken to business owners in a wide range of industries, including restaurants, grocery stores, importers, laundromats, auto repairs, and more. They all complain that they have tremendous difficulty obtaining funds. Look no further than the charts I posted here in July 2017, and in November 2017, reposted updated versions here. It is my opinion that these difficulties have arisen because there is too much risk for banks to lend with such a small spread between their borrowing cost and their lending return. This is another indicator that the necessary liquidity is not making its way into markets and the economy.

Removing Liquidity – Let’s look at another analogy. Imagine that you are sitting in driver’s seat getting ready to turn the key and start the car. After a minute or two, you put the car in gear, and as you are driving you see some smoke coming from the engine. Luckily there is a service station one block away, and as you pull in the engine grinds to a halt. When the mechanic opens the hood and the smoke clears, he tells you, “It’s obvious, there’s no oil! When was the last time you checked the oil?”

Motor oil is to the engine just as liquidity is to the economy. Without liquidity, transactions cannot be completed. The Fed and other central banks are removing the motor oil of the economy, which we call cash. Without cash, the economy will come to a grinding halt like a car engine without motor oil.

Yes, the Fed and other central banks are removing liquidity in highly dramatic fashion. And this is the point of all this. With all of these unprecedented central bank moves that we are seeing now, in the US, in England, and in the EU, removing liquidity is deflationary, which is the death knell of central banking. They are removing cash from circulation. How this is happening is because they are both selling bonds and other securities as well as raising rates. If they sell and collectively we buy, the Fed retains all that cash in its vaults. This will be highly deflationary because cash will be moving out of circulation and into the Fed’s vault. As low as the velocity of money is now, it will sink even lower. It’s similar to removing the bid for shares stock. If there is no bid, the ask price must fall until a bid exists.

Inflation/deflation in the form of rising/falling prices only happens when three factors all work in tandem, which are the velocity of money or circulation, addition or removal of money into or from the system such as printing, and perception which is what everyone thinks is going to happen to prices…all three must work together for us to see inflation or deflation of prices of things like beef, potatoes, and gas at the pump. The deflation I see coming will not happen at first because The Street is euphoric like a frat boy wearing his first pair of beer goggles.

Fed officials may think that this pull back in liquidity will cause the remaining currency to circulate faster, but they are mistaken. The circulation rate will take too long to increase and catch up to the removal rate. The reaction on The Street will be slow at first, but even as I write this, people are catching on. They just don’t realize why yet.

The balance sheet reduction at the Fed is looking like it will be over $1.25 trillion. Also, if the Fed is hiking rates, as noted, more and more cash will be diverted by businesses and households to pay off debt. Banks will NOT relend that cash back out because it is just too risky (and becoming more risky as the yield curve flattens further and eventually inverts), and there is no return on that capital for banks. I’ll borrow a phrase from resource sector legend Rick Rule here, and call this type of lending return free risk. Banks are in the business of getting paid back whatever they lend, and making a profit on those loans.

As all this cash comes out of our collective pockets and into bank vaults, that cash will stay on the sidelines and put massive deflationary pressure on everything…houses, stocks, bonds, commodities, Da Vinci paintings, collectables, and anything else you can think of. Prices are set to fall like a rock in a pond. Just like the rock falls, so too prices will fall, but remember there is also a ripple effect when the rock hits the surface of the water, which I’ll get to soon. For now, it suffices to say that 2008 will literally look like a picnic compared to what’s coming.

Lending

This brings me to lending. I’ve already mentioned a few points above, but it needs more attention to detail. As we’ll see, the situation is much worse than I’ve already stated. I can’t emphasize enough that central banks around the world are removing liquidity from the economy, which will lead to a ripple effect in the banking sector as well as anything that banks have a hand in. This leverage will cause a massive insolvency, the likes of which we have never seen, making every other economic downturn combined in the history of the country look like child’s play.

Charts – Lending is falling. Really a free fall, and it will get worse. I first published a series of charts from FRED of the St Louis Fed in July and reexamined the same charts last month (both articles are linked above). In dollar amounts, lending is increasing. But we aren’t interested so much in whether or not banks are making more loans. We are more interested to know if the amount of loans they made in the last 12 months is more, the same, or less, than the 12 months before that.

The best way to examine this is in the year-over-year percent change. If the banks lent out, for example, $1, that means they increased loans. But if the prior 12 months saw loans of $10, then that means that even though they increased the amount of loans, they are actually decreasing lending activity. And that is a crucial distinction that a lot of people are missing. Bankers, economists, asset managers, financial media, and more are all missing this critical point. The list of charts includes bank credit, commercial and industrial loans, real estate loans, consumer loans, revolving credit…this is all anathema to anything you hear from the financial talking heads or anything you hear on the nightly news.

I also included charts showing stock buybacks are continuing to drive stock prices, because in another chart we see that stock valuations are going up. That diverges completely from the earnings which may be rising on a per share basis. And yet, total company earnings are falling.

As the yield curve continues to flatten and eventually invert, lending will crash to zero and that event is likely to happen before the inversion. If the Fed continues to hike and flood the market with bonds and MBS, the lending spigot will be turned off. It’s all but guaranteed, and it’s not a matter of if, rather, a matter of when. The infamous dot plot is telling the Fed to hike three more times next year, but there is only about 50 basis points (2 hikes) to go before the curve is flat! If the Fed hikes three times, they’ll force it to invert.

Defaults will begin to rise precipitously, and they are already rising in both Emerging Markets and subprime auto loans. With a more than 100% rise in defaults in the last two months, home equity lines and loans are next. When this all hits, it will hit particularly hard on all banks that lent to emerging market economies with loans denominated in dollars.

You see, as the Fed raises interest rates, in the short term that will help strengthen the dollar. Any company who earns its profits in a currency that is weakening against the dollar, but has to pay back loans in dollars, will have a more and more difficult time as the payments increase. The dollar amount won’t change, but the peso, yuan, rand, or reál amount will steadily increase as those currencies weaken. On top of that, as rates rise, some of those loans which are variable rate loans, will see their interest payments rise along with a weakening currency. So that will be a double whammy for EM loans made in USD. Banks that have lent in this manner will see very high levels of defaults.

The biggest banks (by assets), according to Bankrate, are Chase, BofA, Wells, Citi, Goldman Sachs, Morgan Stanley, US Bancorp, PNC, TD, and Capital 1. To give a little perspective, if you took all the assets of Cap1 ($348.55 billion) and laid it out in $100 bills end to end, you’d make a trip to the moon and almost half way back. If you own shares in any of these banks, or if you own shares of an ETF or fund that has a large position in any of these banks, it would be prescient to watch very carefully, and pay particular attention to their EM loan defaults. Personally, I would call into the next earnings conference call and ask about it, and I would go a step further and challenge the speaker when s/he blows off your question.

In addition to EM loans, credit cards are beginning to see a large uptick in defaults. Since the October of 2013, defaults have been holding steady around 2.75%. In December 2015 with the first rate hike by the Fed, the default rate on credit cards bottomed out at 2.49%. There has been a steady rise since then and we’re now over 3.25% default rate. The last time default rates on credit cards rose to this level was right before the 2007/2008 crisis.

I have mentioned only a few areas of lending here where I see defaults rising and I predict they will continue to rise. I suspect, though, that this issue will spread through the entire banking sector very quickly, and not just the banks, but also private placements, VC, PE, “Shark Tank” style lenders, peer to peer lenders, and anyone else who is in the business of lending. Defaults are set to rise rapidly and the pace will accelerate as the Fed sells securities and hikes rates.

Housing

This sector is going to experience a second round of hard hits. It’s Fed monetary policy combined with some of the new tax laws affecting high tax states like NY, CT, and CA. According to the St Louis Regional Fed, the national median home price peaked in 2007 at $262,600. (The National Association of Realtors has the peak in July 2006 at $230,400.) According the StL Fed, September this year was $324,900, for an increase of 23.7%. Its off by about $12,000 for November (December not out yet as of this writing), but remember nothing goes straight up. There has only been 5 times since January 2000 that the price went up two months in a row, and 4 of the five times was $1500 or less. To be fair there has been only 4-5 times that it went down two months in a row as well. Otherwise, in the last 18 years, it has always been one up and one down.

The Case-Shiller home price index is also close to pre-crisis levels on the 20-city composite. It’s now at 203.50, just 1.46% shy of the peak of 206.52 in July 2006. For the ten largest, the index is currently at 217.69, and the June 2006 peak was 226.29. The 10-city composite is off by just 3.8%. Nationally, the difference is more pronounced at almost 6.0% higher than the prior peak in July 2006.

Some cities are down still, like Atlanta and Cleveland. Some are flat like New York, but there are other cities that are disturbingly higher. Charlotte is up 11.1%, SF is up 18.5%, Portland is 20.2%, Boston comes to mind at 21% higher. Dallas is 42.3% higher. Denver is 44.7%. Interestingly the areas that we might expect to seriously skyrocket…Vegas, Phoenix, southern Florida, NYC, Los Angeles, Chicago…these areas are at or below their 2008 peak.

Dallas has skyrocketed, and I suspect that is because of favorable tax laws in Texas that favor entrepreneurship, business, and low taxes, instead of social welfare entitlements and high, repressive taxes like NY, Chicago, or California. And that gap is about to widen with the Trump tax bill passage, because as we know, people who already pay high real estate taxes and high state income taxes have been hurt with being limited in their deductions on their tax return in those categories.

Defaults – Case Shiller also tracks defaults, and they show similar results to other sources, that primary home loan defaults are falling. But the canary in the coal mine for mortgages is second or subordinate loans, which is home equity loans and lines of credit. In 2007 it was subprime. Now we only see rising defaults in second mortgages. From June 2012 until now, it’s been steady as she goes in a range of 0.50%-0.75%. But from September 2017 through November 2017, the index has spiked from 0.53% up to 1.08%. And I get it, 1.08% is not too bad of a default rate at all. It’s certainly better than the post crisis range of 3.5%-4.5%, but what we are looking at is 104% increase in the default rate in just two months. That’s a figure I’ll be keeping my eye on, and it will be interesting to find out where the defaults may be concentrated and why

Defaults on primary home loans are in a range of 0.65%-0.75%, and if we see this rising, which I suspect it will, it will spell trouble as the default rate begins to move past 2% and up to 3%. I also suspect that as subprime lending standards continue to loosen (I’m already seeing adverts for 100% financing with low or no credit), as home purchase prices continue to rise, and as adjustable mortgages come into vogue again, subprime defaults will accelerate past second mortgages. These are the least qualified borrowers, and we already see it in subprime auto-lending with some loans going into default as soon as the car leaves the lot with the very first payment being missed.

One more important point is defaults on loans of all types, and leases too for that matter, defaults are a lagging indicator of economic stress. If it stays in a range, I wouldn’t worry about small upticks within that range. But once it moves assertively and significantly out of its established range, warning bells begin to ring. If we already see defaults rising, it means that the economy is already doing worse than we thought.

Spikes in loan defaults are more common just before official recessions are declared. So if we see defaults rising in the last three months, it could mean that the economy has been more sluggish than we think for 6 or more months. Therefore, if the trend continues upwards, we know what is coming…the widespread realization of what is already here.

Stock and Bond Markets

I’ve been through stocks and bonds with every article, and I don’t want to rehash what I’ve already stated in those postings or above in this one. It’s just beating a dead horse. I will add a couple summarizing comments, though.

By all measures stocks are completely over valued at this time. Warren Buffet’s favorite metric is stock market total market cap to GDP ratio, which is 143%. The historic average is around 50%. And worldwide the current ratio of total stock market cap to total world GDP is in excess of 350%!!! All other measures are also in the stratosphere.

Truthfully, the ratio should be higher because the denominator, GDP, was recently changed. Under GAAP accounting rules, any company that has a budget for research and development writes off cost as an expense. The government now adds R&D into the investment part of the GDP equation. Until recently that was never included because it is not a final product or service. So the ratio should have a smaller denominator, and hence, a larger ratio of stock market value to GDP.

Because S&P companies have very strong balance sheets and profitability is very strong as well, there is some staying power here for stocks, and I emphasize some. As such I am adjusting my perspective to say that I can see the stock market taking itself another 5-7% higher based on the tax cut expectations and current momentum. That puts the DOW, which had 71 new all-time highs in 2017, at a range of 26,080-26,580 based on its high of 24,837.51 on December 28, and the S&P’s high of 2690.16 on December 18 may go to a range of 2825-2880.

However, as I’ve noted already, as interest rates rise, balance sheets, income statements, and the staying power of such will deteriorate. Also, as interest rates rise, government bonds of all types may become more attractive, which will cheapen the value of dividends being paid. That’s because if you’re an income investor and you’ll be able to de-risk your current 1.8% S&P dividend (another historic record, a record low) by purchasing treasuries or munis, you might give strong consideration to do just that. It will cause equity prices to come down with selling pressure.

The historical mean for the S&P 500 dividend yield is 4.37%. Believe me if something hits the fan on our economy, the current dividend will fall precipitously along with the index, even as the dividend yield rises. That means that if the current dividend reverts to the mean dividend yield, we’ll see the S&P 500 below 1100. If the dividend falls, which is likely to happen, the S&P 500 will fall even lower for the dividend yield to revert to the mean. Usually what happens, based on the historical chart linked here, dating back to the late 1800’s, the stock market will grossly overshoot. If that happens again, you’ll probably be able to pick up the index with a dividend yield north of 7%.

In addition to central banks paring back QE or selling bonds and MBS, there is a very high level of bond fund outflows as well. As the funds sell, that will add even more selling pressure which translates into falling prices. Of course, if the price of a bond falls, you guessed it, the interest rate on that issue must commensurately rise.

For junk bonds, which is non-investment grade, Reuters says the week ending November 15th saw the fourth largest outflows on record since 1992 when the statistic began. Marketwatch has the same period, ending November 17th, as the 3rd largest outflow on record. And Lipper shows the trend has continued through the end of the year. Several billion in outflows from bond funds, and in weeks of buying, inflows are shrinking. Over the same period, there has been several more billion in outflows from bond ETFs as well.

When compared to the total US bond market of over $40 trillion it doesn’t sound like much, but if you consider that in the context of rate hikes and Fed sales, institutional and retail investors are worried that their principal investment is going to fall in value, and they’re 100% right. I don’t attribute it to tax selling because the fever pitch of tax selling is typically the very last week of December. This selling was in November.

The last three weeks of December saw bond fund and bond ETF outflows in excess of $10 billion combined. The Financial Times reported on 12/22 that the prior week saw the highest outflows since Trump became president. Bond funds in developed markets lost $4.1 billion. Bond funds are generally for one purpose: income. If investors are pulling out of bond funds, it means they think that either there are better opportunities for income, or they are protecting against loss.

Along with the outflow from funds and ETFs, we don’t see a commensurate inflow to stock dividend/income funds, high yield funds, or emerging markets bond funds. The catch here is that we know interest rates are in a rising environment, so investors might be pulling out now to protect their principal, and waiting for that anticipated third rate hike next year to go back in at higher yields.

It’s just not clear at this time where they are parking the cash because money market funds are also seeing net outflows that are outpacing bond fund/ETF outflows and equity fund/ETF inflows in all categories of funds and ETFs. That tells me investors are completely pulling cash out of their brokerage accounts to pay for stuff. Further, the savings rate is now at a paltry 2.9%, which was last seen before the last recession. I’ve mentioned previously that I think people are paring their brokerage accounts, preferring to pay down their margin debt (even though margin debt is at all time highs), variable debt like credit cards, pay for living expenses, and make holiday purchases. And I reiterate that now, in light of this new research I’ve done.

As noted many times, bonds work in an inverse relationship between the rate and the price. If the rate goes up, then the price must go down. Rates have not begun to rise in earnest yet, but mark my words by next fall we are likely to see a dramatic turn of events in bonds. As noted, the Fed is in the middle of rate hikes. As the rate rises the price of bonds must fall. They are also in the midst of ramping up sales without commensurate buying to mop up the supply. As the price falls the rate must rise. The government runs a budget deficit of over $650 billion and rising, and that will add even more supply to a market that is beginning to flood.

Taxes

I’m not a big fan of the tax bill. There are some great provisions, for sure, but overall I am not a fan. I made some of my own tax reform suggestions here, in case you are interested. You can see a good summary of some of the bills’ winners and losers here. Let’s have a little bit of a look.

On personal returns the average American will receive over $1600 on their tax cut (about 55% of Americans pay no taxes at all so you can’t cut taxes from 0), and the standard deduction was doubled as was the child tax credit. But real estate taxes on your primary residence plus state and local taxes now have a maximum tax advantage of $10,000 combined. That will hurt anyone who lives in states like New York, CT, NJ, IL, and CA where there is a very high level of social welfare entitlements and high taxes. Places like TX and FL won’t be hurt so much because they have low real estate taxes and low state and local taxes. Some people will pay more, but most will either continue to pay nothing or get a reduced tax bill by an average of $1600. And the more you pay in taxes now, the more you are likely to save on your tax bill in the future.

The $1600 figure comes from the CBO, and the Tax Policy Center is saying about 143 million tax payers will pay less versus about 8.5 million tax payers who will see an increase. Congress’ own Joint Committee on Taxation is crunching similar numbers to the CBO and TPC.

Another big line item in the bill was 529 college savings plans may now be used to pay for K-12 private school tuitions. That is very big for anyone sending their kids to Catholic School, Yeshiva, Friends Schools, Medras, or any other private primary/secondary educational institution. It will be a big deal for those institutions too.

The big problem is that the same agencies mentioned above are finding that cutting taxes will take away about $2 trillion in tax receipts over the next 10 years, while the projected GDP increase will bring back only $400 billion in new tax collections. On net balance, over the next ten years, prior CBO projections of no less than $600 billion in budget deficits every year and growing by no less than $50 billion each year, will have to add $140 billion per annum for an additional $1.4 trillion added to the bonded debt of the USA. We’re talking over $10 trillion being added to the national debt in 10 years, just because of budget deficits. At what point do our creditors say enough is enough and pull the plug on continuing to fund deficit spending, knowing they’ll never get paid back in full, and if they do it will be with worthless dollars?

In addition to the provisions I’ve mentioned, there is something else that I have been talking out with people. Everyone who will listen, in fact, cause this is a biggie. Quite a few people have said to me, “Holy cow, why didn’t I think of that?!” In fact, the only other person I know of who has mentioned this issue is Michael Pento of Pento Portfolio Strategies, who mentioned it for the first time this week in his weekly podcast. He said he is the first to mention it to the public, which could be true. But he is not the only person to think of it, and once I mention it to people they have the epiphany.

The issue is the individual mandate was repealed, leaving two problems for health insurance providers. I am not going to talk about the moral or ethical construct of the issue. I am only concerned with the economics here. There are other forums for the ethical and moral discussions, and I kindly ask to keep those discussions in those forums, not here.

One issue is that young healthy people who don’t utilize their insurance will self-terminate their coverage. Insurance companies won’t collect their premiums to offset the costs of really sick people. And that’s the second point is that people with pre-existing conditions like heart disease and cancer can’t be denied coverage. Those people are very sick and have very expensive medical bills because of procedures and medications. Heart transplant surgery, for example, could be in excess of $1 million, bypass surgery over $350K, and cranial malignant tumors could be over $750K. Just for the surgery.

If you remember, Obama promised us that our premiums would drop from $12,500 to $10,000 with the enactment of the Affordable Care Act. You can also read about that here. But realistically premiums doubled or more in most cases. And that includes healthy people paying premiums for insurance that they under utilize or don’t use at all. All those underutilized premiums are about to disappear, and if you think the premiums got expensive in the last 8 years, think again. That will look cheap on election day in 2020, and what looks expensive in 2020 will look like a fire sale in 2024.

Here’s why premiums will go up. I already mentioned that young healthy people who under utilize their insurance will just drop their policies. That takes out a large pool of cash from the insurance companies, which is normally used to invest in the insurance company itself or to make investments in the markets. The goal of all that investing is to turn a larger profit. The premiums being paid in will come from sick people and families with young children. These groups typically over utilize their coverage, meaning that the insurance companies will pay out more cash in claims than they can raise in premiums. Insurance companies are not in business to lose money, so they’ll have to raise premiums to make up the difference. If your premiums went up when the individual mandate was included, a fortiori they’ll go up without it!

It’s not just families that will be hurt by this. Companies made out good on this tax bill because corporate taxes are dropping from 35% down to 21%. By the way, taxes are an expense, and all corporate expenses are built into the final price of goods and services at the point of sale. So companies really don’t pay taxes. The consumer that buys their stuff really pays the taxes.

In any case, the big “but” on that corporate tax reduction is that, like individuals and families, companies that offer and pay for medical benefits to full time employees will see those premiums rise very quickly, even with discounted group costs. Insurance companies know that people will be dropping coverage, and they know the risks that accompany the remaining people who are sick. They can calculate the risk and mitigate it mathematically. But there is a big uncertainty and that is how many people will drop coverage and how many new people will apply. And what are the costs going to be for all those new people? And more importantly, what are the uncertainties that lie ahead in the healthcare arena’s regulatory environment? Chances are that more people will drop than anticipated, and more sick people will apply for coverage than anticipated. And chances are that the costs for the new applicants will be higher than we expect.

You know, agree with the president or not, vote for him or not, Trump is a smart guy, and it could be that he has a plan for the fiasco he just created. It could be that his plan is to show everyone how economically unfeasible the ACA really is, and thereby the people will clamor for real and lasting structural change in the health care insurance industry. When that happens, we’ll see Trump open the doors to a more competitive atmosphere, for example, by allowing companies to sell across state lines.

I am sure that other innovations will take place in the health insurance industry as well. For example if your religious beliefs preclude you from certain procedures or medications, you may be able to opt out of those. Maybe women who’ve reached menopause won’t have to pay for birth control medications or procedures. Many other innovations may appear as well.

While there are some positive developments of the tax bill, I think the negatives will exert too much downward pressure on the economy. It will leave GDP growth projections of 5-6% in fantasy land, and the high expectations will be short lived.

National Debt

The national debt is a very big issue, and it probably should be near the beginning of this article. Also, more attention should be given to it in the media. And you, dear reader, should pay more attention as well. Here’s why. The current level of bonded debt (think treasuries) is $20.62 trillion. The current level of future liabilities that are not yet bonded, but for which the government must borrow in order to pay for those liabilities is estimated at an additional $80-$100 trillion total for each and every person now living in the USA. What that amounts to is future promises to pay social security benefits, Medicaid, Medicare, and any other benefit that has been promised by law.

As noted many times, the current annual budget deficit is over $600 billion, and that is set to grow by no less than $50 billion per year. Also, those $80-$100 trillion are not line items in the budget. They are items that are not included in the budget, meaning that if there is a budget deficit of $650 billion this year, the government has to borrow that amount plus more to pay for its welfare obligations. It is for this reason that you can see a budget deficit of $650 billion, but the national debt rose by significantly more.

I have seen study after study showing how nations with a national debt exceeding 90% of GDP will be guaranteed to have a day of reckoning on their debt. Whether by blatant default or restructuring, either way the creditors of those nations will have to take the proverbial haircut. National debt in excess of 100%, that day of reckoning will be both sooner and more harsh, and this is considered the point of no return.

As I write this, America is now at 104.99% debt-to-GDP ratio. So where is all the clamoring for restructuring, why isn’t Wall Street crying over losses, and why aren’t insurance companies changing the structures of their annuities and life insurance policies? Why isn’t anything happening on this front? Where are the academics who wrote those studies about the debt to GDP ratio?

Here’s the rub. The debt to GDP ratio is important, but it is not the only component of that equation. To understand, here’s an analogy. Imagine a recent CPA candidate just landed his first job at one of the big accounting firms, and they are paying him $70,000. Then he goes and buys a condo on Central Park West for $10 million, with an interest rate of 0.00%. He doesn’t have to do anything to service the loan because no interest is due at any time. But what if the rate suddenly rises to 0.1%? His interest payment is now $10,000 per year. Still affordable, though he might consider paying off his student loans and some other debts, and he may also reconsider which restaurants he dines at with his girlfriend. What if his interest rate rises to 0.7%? All of a sudden, all of his income must be used to pay the interest on his mortgage, and he has nothing left to pay for anything else.

This is the same situation that the USA finds itself in. The national debt is currently sustainable. But as interest rates rise, either by Federal Reserve policy, by market forces, or by both, the debt will become less and less sustainable. Eventually America’s creditors will realize that they are not going to get paid back in full, and there will be a rush to the exits.

According to treasurydirect.gov, the current interest rate for all marketable and nonmarketable treasury debt (does not include TIPS or floating rate notes) is 2.293%, which comes out to $472.6 billion of interest payments per year. That is just over 14% of total tax revenue (which is set to drop, see above). As the national debt and the interest rate on that debt both rise, it will eat up more and more of the federal tax revenue. That’s because federal tax revenue will not continue to increase as fast as the debt service payments.

And what do you think the government will have to do to make up the difference? That’s right, it will issue more treasury debt, it will print, and it will commence more monetary policy moves that will have a negative impact in the long run, even if emergency measures provide temporary help in the short run. Everyone around the world will have to recognize the truth of the situation, that the full faith and credit of the US government can’t coexist with the insolvency of the US government.

The situation is currently sustainable, but as interest rates rise, as the debt rises, and as tax revenue falls, a tremendous amount of pressure will inevitably be exerted in this area. The end of this particular saga will not be good, and everyday Americans will be hit hardest. As the value of the dollar falls, everything we import will become more and more expensive, and that will cause domestic goods to rise in price as well.

Bitcoin

I don’t know where Bitcoin ends. Or any other crypto currency for that matter. It could be $100,000, it could be $1.0 million, or it could be $150. It could even be zero. What I can tell you is that the blockchain technology behind it is here to stay. Well, until we find something better. But for now it’s here to stay, regardless of what happens with the crypto currencies. Just don’t let the crypto currency story become kryptonite to your portfolio.

I also think that this cryptomania is indicative of what the concerns are with fiat currency. People are looking for a real store of value, which fiat currency is not. And they are also looking for something which forces the government to butt out. Fiat sorta does that, but it sorta doesn’t. Crypto is actually a nightmare scenario if you are a flaming libertarian or anyone else who can’t stand governments poking around your personal business like the school nurse looking for lice before allowing your kid to come to class. In the end the cryptomania bodes well for other assets, such as gold, silver, and the mining shares.

I have several concerns with Bitcoin and all other cryptos, though, including hackable (it’s been done several times already with several cryptos including Bitcoin), it’s multipliable (over 1200 cryptos and counting, and each coin brand can be increased in total number), it’s not widely accepted yet, and it’s not physically transportable so if your power goes out you may lose access, and many other problems.

The biggest problem in the cryptosphere is the uncertainty of governments and their propensity for sweeping intervention. China and Russia have already announced they’ll be introducing a national crypto currency, and Israel announced last week that they’re beginning to look into the matter. Several countries have also made it more difficult to use the currencies in their markets, with the latest being South Korea. Other nations will follow very quickly.

Here in America the problems with the government are many. I work in the financial services industry, and we have several regulations in anti money-laundering, know your customer, bank secrecy, FATCA, suspicious activity reporting, the Patriot Act, and more. Ever try to deposit a few thousand in cash? The teller calls over the branch manager and they start questioning you like FBI agents. Behind your back they’ll file mandatory reports after you leave. Last time I deposited a couple thousand I just said, “My tax refund finally came in and I have to make a mortgage payment, so I took cash out of my account at the other bank to deposit here for immediate availability.” It was true, but they gave me a weird look for that one, like if I was hiding money for Al Capone.

Cryptos fly in the face of all of these regulations. The regulatory climate in the banking and financial industries has been designed to help track down drug dealers, terrorists, mobsters, and others with foul intentions for society. None of the regulations are being kept in the crystosphere, and believe it when I say the US government is ready to swoop in. They are just waiting for the most opportune moment, and meanwhile they get a front row seat to observe the latest innovations as well as public sentiment.

What it means is that if we have a FedCoin (or whatever they’ll call it), all transactions can be traced, no more tax evasion, no more cash, it will be an invasion of privacy of the highest order by law enforcement agencies, and we all lose freedoms. I am not a conspiracy theorist by any means, but the history of government involvement in money and currency leads me to believe that this time will not be different. Only the currency will have a different name and a different picture on it, but the story will remain the same…government takes on too much debt, government can’t pay debt, government debases currency, government defaults and monetary revolution ensues.

The United States and other countries are just waiting to see how the crypto story plays out. The private sector is in the midst of perfecting the next phase of currency history, and governments will take over soon enough. As soon as Uncle Sam comes in, FedCoin will be the only legally accepted cryptocurrency in the country, rendering all others useless and valueless.

In relation to gold, there are two points to ponder. One is that crypto is not a substitute for gold, even though some people may claim it is. It doesn’t share all the same properties as gold, even though it shares some, and it will be traceable by governments, whereas gold is not. In the short term, individuals may play the crypto market and make a killing on it or they may get killed on it.

The second point is that even though gold has temporarily lost its luster, the cryptosphere is indicative of what is coming for gold, as noted above. A growing number of people understand the complete farce of fiat currency systems, and that gold is the only true world currency alternative that outlasts everything. Afterall, there is over 5000 years of written historical record attesting to gold’s utility as both a currency and a store of wealth.

Gold

Back in May 2017, I laid out the case for owning gold. When I posted that blog it was 19 pages single spaced. We clearly don’t have the time for that much here, so I’ll just touch on the major points. If you want to see it, just click the link.

Ok, so gold has an economic function as both a commercial/industrial metal and the more important function as real money. It’s used in electronics, satellites, jewelry, life-saving medical equipment, and much more. As money it is the only store of value that doubles as currency, and stands the tests of both time and geography. If you price anything in gold rather than your local currency, the value of everything in the world remains relatively constant for looong periods of time. Also, it is the one true safe haven asset in times of uncertainty and worse, during hyperinflation and war.

Next, gold does not pay dividends, and that is not why you own gold. Though I know of a hedge fund that now specializes in owning gold and receiving a return on your gold in more ounces. You own gold because 1) it hedges against inflation, and 2) it acts as portfolio insurance. Most importantly it functions as an asset to which there is no third party counter risk such as banks, stock exchanges, or governments. Also, gold is the only international currency because no matter where you go in the world, one ounce of pure gold retains the same value in all places and at all times.

Next is that gold can’t be printed like the cash in your pocket. There are costs to bring it out of the ground which are rising, and the world gold supply increases each year at about the same pace as population growth... 1.5-2.0%. Not only that but nearly the entire supply of gold ever mined is still in existence and still in use somewhere in the world, unlike other metals that typically end up in the garbage dump, such as copper, zinc, plastics, fabrics, and others.

At this time central banks around the world are becoming net buyers of gold…Russia, China, Turkey, India, and several other EM nations and Asian nations. This is because all the other central banks of the world, especially Western central banks, are in a race to the bottom to devalue their currency, hence, the reason asset prices in all categories have exploded in the last decade. See, if your unit of measurement becomes smaller and smaller, then you need more and more of those units to measure the same value of an asset like an ounce of gold, a single family home, farmland, or a painting. In addition to central banks becoming net buyers, the most reputable investors around the world are buying as well... George Soros, Li Ka-shing, University of Texas endowment fund, and many more.

And then there are several economic cycles all coming together at once, including the rise and fall of all fiat currencies including the dollar, the lifecycle of baby boomers, Kitchin waves, Juglar waves, the wealth distribution cycle, the stock market cycle, Kondratiev waves, and the East-West grand super cycle.

My prediction for gold in 2018 is to test its 2011 high of $1948 per ounce, and silver will test $50. In the next 3-5 years, we could see $3000-$4000 per ounce with silver reaching $125+, and in 5-7 years, we are likely to see $8000-10,000 per ounce of gold and $300+ per ounce of silver. This will happen because the Fed has failed to bring rates high enough and fast enough. They should have started rate hikes much sooner, and it should have been much faster. Remember that in the last two easing cycles, rates came down by 5% or more to restart the economy. When interest rates in the market hit 4.5%-5.0% on the 10-year treasury this coming fall, the Fed will have no choice but to immediately drop the Fed Funds rate from 2.0-2.25% back to zero and go -2.5% to -3.0%, and reengage QE. As that unfolds the dollar will also tank, which bodes well for PMs.

Energy

Oil and gas are becoming more difficult and more expensive to bring out of the ground, and the price to do so per barrel of oil is currently around $60. If the price per barrel is below that, companies will only tolerate losing money for so long before low prices are cured by more low prices. What will happen is we’ll start to see more and more exploration funding getting cut off, and more oil well closures. We’ll also see consolidation in the industry. So eventually prices will rise and companies will outperform expectations.

Even though the Trump tax package opens up ANWR, that will still require years of further exploration, preliminary economic assessments, permitting, and building of wells in one of the most difficult drilling regions on the planet. It will also require the infrastructure buildout, because it’s not so easy to just drill a well and carry several million barrels of oil equivalents across the frozen tundras of Alaska and Canada.

In addition to oil and gas, there is the issue of uranium. We are at a juncture whereby the choice is either continue mining uranium and using it for reactors, and building more reactors, or the lights go out. I suspect the world will choose the former over the latter, because all the other sources of energy, such as solar and wind, are just not efficient enough and aren’t cost effective enough to be viable on the scale that is needed to replace nuclear energy.

The rebound in nuclear energy will be a function of Japan coming back on line with its nuclear facilities as well as more plants opening around the world. In fact, the first nuclear power plant in several decades in the US was just approved in Georgia. We’ll begin to see more of that as old plants close and the need for energy grows with the population, power hungry gadgets, and electric cars. Also, China has over 400 reactors either in the planning stages or are already under construction.

The spot price of uranium is currently about 60% below the cost to bring it out of the ground. Like oil, that will change and uranium companies, with such perversely low expectations right now, will both outperform expectations and also positively surprise Wall St. In addition, in the last 4 weeks or so, we saw Cameco (CCJ) close one of the largest mines in the world, which effectively cut 10% of world production! In addition to the Cameco cut, the state owned uranium company in Kazakhstan, Kazatomprom, will close one of their largest mines as of January 2018. That mine alone is 20% of the company’s production.

The combined world production between these two closures is well over 25%, and that is why uranium prices moved higher by 20% in the days following those announcements. Expect to see more closures, more consolidation, and more streamlining of business models. We are now seeing the beginning of a capitulation by the professionals in the industry, and as we see more of this, this subsector of the energy domain will begin to do very well.

Recommendations

Everyone reading probably wants to know what to do.

The single most important thing to invest in is your own financial education. People who do so tend to be better off financially, and they know when to question the “wisdom” of the Street. I like Robert Kiyosaki’s Rich Dad Poor Dad. It’s a fantastic book and it’s the best selling personal finance book of all time. I also like Mike Maloney’s Guide to Investing in Gold and Silver. Mike is the foremost expert in the world in the big picture of the gold and precious metals arena. I also recommend his YouTube video series called “The Hidden Secrets of Money”, which is a primer on how the entire financial and banking system works.

Before you even buy these books, let alone read them or watch the YouTube videos, you must, must, must call your stock broker if you still use one, and ask that person “How will the current climate of rate hikes and Fed balance sheet reduction affect my portfolio?” Your money manager should welcome this question for two reasons. One it makes his job easier because he doesn’t have to prioritize if he should call you. But more importantly it sends a message that you care about what happens to your money, and he should too.

The answer to that question should be “I’m glad you called, and many clients like you have similar concerns. That is why we are taking a proactive approach to make sure you’ll be able to protect what you have and hopefully grow it a little bit too. When can we get together to discuss it in the next week?”

If your money manager doesn’t welcome your phone call and the question, and instead blows you off in any way at all, perhaps the next question you should be asking yourself is if your money manager is the right guy for the job. Is he fulfilling his fiduciary responsibility first, before he thinks about making his wife’s Mercedes payment?

Beyond that I have some bold recommendations of what you can do right now with your portfolio. First is that as I said in November, gold ownership is now mandatory. You better get in while it’s still cheap! You can buy bullion coins and bars from many different places, but I would not recommend most of them. Especially not the companies that have big radio and TV advertising budgets.

There are several companies of good repute, like Schiff Gold, GoldSilver.com, and Miles Franklin (not paid endorsements). How much physical gold bullion you own depends on your situation, but investors would do well with a 10% position in bullion (and that is 10% of total investable assets), and build a position in mining companies after that. Investors should avoid numismatics, they aren’t worth the price and they don’t serve the same function as bullion. Also, it’s important to avoid the gold ETFs like IAU or GLD. You just aren’t entitled to redeem your shares for real gold, and the ETFs dilute your value. It says as much in their prospectus, usually between pages 5-8.

Also, if you didn’t read my article on owning gold, go read it, and pay attention to the scams and shams to avoid. Schiff Gold has an excellent pamphlet on the scams and shams too, and they’ll give it to you for free if you are willing to give them your email address.

The second half of the gold story is in the mining companies. It’s important to do your own research. If you don’t know how to do that, you can buy an ETF or mutual fund, and some are much better than others. Personally I am in the EuroPac Gold Fund (EPGFX), and both the ALPS ETF/Sprott Gold Miners (SGDM), and ALPS ETF/Sprott Jr Gold Miners (SGDJ). Precious metal streaming companies will also outperform, and my favorites are Franco Nevada (FNV) and Wheaton Precious Metals (WPM). WPM is formerly Silver Wheaton.

All three funds are selective of which miners they buy, paying careful attention to who runs the companies as well as some other fundamental metrics. These funds don’t just spread out their umbrella over the mining industry and buy whatever fits in. They also have small positions in both silver mining companies and platinum metals group miners. These guys are set to outperform gold miners, but the main focus of the funds is gold. Outside of precious metals, the base metal zinc is already warming up, and copper looks good too.

I also like the energy sector, I’m starting to warm up to it here for the reasons above. I think it’s still a little early, but that doesn’t mean you can’t find excellent companies, priced at a discount, and poised for several solid years ahead as the underlying commodities rise in price. Uranium companies will do well, but if you want a more direct play on the metal you can go Uranium Participation Corp (OTCPK:URPTF). The major oil producers will handily perform for you as well, streaming companies such as Freehold Royalties (OTCPK:FRHLF) will also give you handsome returns with a fat dividend, and some of the midstream and servicing companies will also do well and pay dividends.

Another very big recommendation right now, perhaps the biggest, is to pay off all your margin debt and get into cash. If you have the cash to pay it then that is the best way. If not, sell something at a profit and pay the taxes if you have to (speak to your CPA as well). If there is a crash like 2008, and if you have a high level of margin debt against your account, you’ll be toast. Don’t think twice, just pay it off and don’t look back. Sell for profit and pay the taxes because the losses in a crash will be higher than the taxes on the gains if you don’t.

Not only paying off margin, but I also recommend very high levels of cash, starting with at least 25-30% of your investment portfolio. First of all, I’d rather miss out on the next 3%-5% upward move rather than suffer 50% or more in losses. Secondly, when it all does hit the fan, there will be tremendous opportunities on the other side of this crisis to pick up companies like Apple (AAPL), Starbucks (SBUX), General Electric (GE) at extreme fire sale prices. Apple, for example, in 2008 was well over $200 per share, and at the bottom in 2009 you could pick up shares for around $60. Starbucks bottomed around $5-$6. GE more than quadrupled from its March 2009 low of $7 to its recent 2016 peak over $30. Like Johnny and Baby in Dirty Dancing, we’ll surely see companies like these doing dips again.

I really don’t like banking stocks right now, and I wouldn’t touch them with a 10 foot pole. Especially those US banks that have lent to EM companies denominated in USD. Yeah, I know, the Street is in love with banks, but all the analysts work for banks. Go figure. Investors might consider a small short position in the banking sector to hedge against general stock market losses. You can accomplish this with an ETF like the Financial Select Sector SPDR Fund (XLF) or the Vanguard Financials ETF (VFH). I have nothing against these two ETFs, and they are just examples of vehicles that you may or may not choose to employ.

A small hedge against the broad stock market with a short position in US stocks might make sense too. If you don’t sell and take profits, and rather stay all in, when it hits the fan you’ll be able to recoup some of that if you short the market. The most popular ETF probably would be the SPDR S&P 500 ETF Trust (SPY), but any index ETF will do.

The single most obvious short is treasuries, because the Fed is hiking and selling, and the yield curve is only 50-60 basis points from inverting. Again, if the yield is rising, the price MUST be falling. You can use any treasury bond ETF such as iShares US Treasury Bond ETF (GOVT). the short end of treasury durations makes the most sense here. 30-year treasuries fell by 30 basis points in 2017. 10-year treasuries fell by a mere 3 basis points, but since just September the yield has risen 37 bps. And 2-year treasuries have risen by 70 bps. Because of this trend, iShares 1-3 Year Treasury Bond ETF (SHY) might be a better short position than GOVT.

Aside from energy, precious metals, and cash, I also like selected defense stocks. One thing not considered by the financial mainstream group stinkers is war in either North Korea or the Middle East. Regardless of the North Korean softened stance in the last couple days, I am more concerned with North Korea right now, but there are rumblings in the Arabian Peninsula too. If Trump makes any comments that lead us to believe he will move in either arena, companies like Northrup Grumman (NOC) and Lockheed Martin (LMT) will benefit handsomely. Again, you must, must, must do your own research here.

But it’s not just NK tensions, Iranian nuclear ambitions, or Saudi shakeups, it’s also the fact that Trump campaigned on ramping back up on military strength. And it shows in his budget proposals. I believe him when he says he’ll spend on the military, because many of the things he said he will do in his campaign he is already done with or in the midst of doing.

Aside from defense stocks, defensive plays are also good positions, like electric companies, water companies, and staples like food and beverages. Do your homework and don’t just buy anything with a pulse.

One final area to keep a watchful eye on is cannabis. Weed. Pot. Marijuana. Mary Jane. Grass. Reefer. Joint. Texas Tea. Pakalolo. Hashish. Ganja. Skunk. Boo. Call it whatever the hell you want, I don’t care. Medical marijuana is in full bloom, and recreational is blossoming. It’s a multibillion dollar industry set for massive growth, and California is only the latest state to add it to the list of legal substances. As other states see the tax revenue being enjoyed on the left coast, they’ll clamor to join. In the next 3-5 years, it will likely be legal across the nation, and you won’t have to fly to the Netherlands anymore just to smoke without concern of arrest. Just a word of caution here... stay off the pump and dumps, and stay away from their stock pimps.

All these moves I am suggesting will probably protect your portfolio and add cash dividends, but the real growth with come from gold and gold mining companies. Like I said I think gold will test its 2011 high of $1948, and if the Fed reverses its sales of treasuries and MBS, and instead goes to more quantitative easing, bail ins, bail outs, helicopter money, universal base income, negative interest rates, and whatever else they can do, we’re in for massive inflation like we haven’t seen in America since long before the 1970’s. we’ll see a hyperinflation that will have “it ain’t worth a continental” written all over it. We’ve had four rebirths of our currency just since 1913, and it can and will happen again. I don’t know if 2018 is the year. It’s just not a matter of if, but rather when. What I do see is that by October of next year, like I said gold could be testing its 2011 nominal all time high and we could see the ten-year treasury bond at 4.5%-5.0%.

Thanks for reading and I’m looking forward to the comments that come in.

Disclaimers: The contents of this article are solely my opinion, and do not represent the opinion of this website or its owner(s). You are cautioned to do your own research before making any investment decisions of your own. This is neither intended to be, nor should it be construed, as an offer or solicitation to buy or sell securities, or any other investment product available. I reserve the right to act upon my own advise at any time, including in regard to any security, insurance, or investment of any type herein.

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Disclosure: I am/we are long EPGFX, SGDM, SGDJ, FNV, WPM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: i may initiate positions in any of my recommendations in the next 72 hours.

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