Tax Cuts, Hurricanes, Fires And A Good Jobs Report = Correction

by: Thomas Barnard

The economy is already at full steam, unemployment at 4.1%.

Hurricanes and Fires will provide big stimulus.

Tax Cuts will add fuel to the fire.

Interest Rate hikes appear to be certain.

The stock market will not respond well to higher interest rates.

I am writing this from Buenos Aires, Argentina, which maybe provides a good perspective for this piece. I was riding the subte (the subway) the other day, and a young man got on and started playing Nostalgias, a beautiful tango on the clarinet. I felt in my pocket and came up with a 10 peso note for his hat.

When I first came to Buenos Aires in 1997 the peso was pegged to the dollar, and my contribution at that time would have been 10 dollars. But now is now, and in 2018 ten pesos only amounts to fifty cents. And this illustrates the ravages of inflation.

A Good Jobs Report also Casts a Large Shadow

The jobs report on Friday February 2, 2018 was a good report. The economy had created 200,000 jobs, just north of December. Wages were showing some increase (2.9% percent from the year earlier), unemployment claims were down, and workers unemployed were down to 4.1%. All in all, a good solid report.

But the stock market took it on the chin and the Dow lost over 600 points. And so why would that be?

The First Early Hints of Inflation

It would be my contention that it was not the number of jobs created or the fact that unemployment was down to 4.1%, but that it revealed, for investors, a disturbing fact. Wages had gone up. Why should investors be disturbed that their fellow man was making a bit more money? Because if wages go up then companies will charge more to make up the difference, and so then prices go up, and this is the kind of cycle that could turn America into an Argentina.

The last nine or ten years have not been normal. Wages and prices have been solid for years. In many ways a good thing. Social Security benefits have not damaged the budget any COLA increases. And so pensioners' incomes were pretty much able to buy the same stuff for the same price for years now.

But it is not normal. Normal looks like this: The economy bounces out of a recession, demand for houses, goods, and so on, is strong. In the old days, this demand for product would stir unions to ask for higher pay, the UAW would single one of the automakers out for special treatment, and so the cycle begins. Wages were higher, so product prices went up, the Fed would begin to raise rates to curb demand, and so fulfill their main mission, to keep the currency stable. A couple rate hikes later, the market falls back. Demand falls off, briefly, and then the whole thing starts again.

Unions have been progressively losing power. Auto plants have been built in states where unions are weaker, or in Mexico under the NAFTA agreement. But it's a lot more than that. Jobs are still being sourced out of the country. Used to be China, but sometimes that's too expensive and the jobs go to Malaysia, or wherever pay is less. During the recession, a lot of workers were converted into contractors with straight pay and no benefits.

You could rightfully argue that labor had overplayed its hand. It had pushed hard for defined benefits, and it damaged industry. The steel industry never really recovered, and I think a case could be made that they set General Motors on its course toward bankruptcy. The New York Times article focused on a fast food employer, Mooyah Burgers, Fries and Shakes, a fast food chain. And this is where I think eminent liberal journalism can go down the wrong path. It has anosmia. It does not smell money.

The Upside of the Hurricanes

Where do I think the money is? Where insurance companies are writing out checks like no tomorrow, in California where they will be building 8,400 homes after one of the biggest fire seasons in history, in Florida after Hurricane Irma, and especially in Texas where Hurricane Harvey may have caused as much as $200 billion in damage.

When I saw in the news that Texas contractors wanted legal work permits for Mexican workers, I smelled higher wages for Texas construction workers. Demand is high.

This is demand that will remain for a good long while as suffering homeowners wait for their homes to be re-built.

So, returning to the normal cycle. When the Fed smells inflation, it begins to raise rates. Well, the Fed needs badly to get its house in order. It needs to de-leverage its balance sheet and sell off its huge mortgage bond portfolio. It needs to raise rates if for no other reason than to put something back into the cupboard so that in the event that action needs to be taken again, they can do something about it.

So, the Fed raised rates three times in 2017, and more are in the works, and that calls to mind Marty Zweig and his book Winning on Wall Street. Zweig paid attention to a number of monetary signals including moves by the Federal Reserve. Rather than concentrate on the specifics of his system I want more to establish that we are moving toward a normal cycle, and in a normal cycle, the Fed raises rates to curb economic activity, and hence, curb inflation.

What De-Leveraging the Fed's Balance Sheet Will Mean for the Stock Market

De-leveraging means getting the mortgage bonds off the Fed's balance sheet. It means selling those bonds, and that means taking cash out of the system. Remember, part of this stock market advance could be seen to some extent to be artificial. That is, the Fed bought large amounts of mortgage bonds and when it bought those bonds it put sums like $80 billion a month in investors' hands. Investors, not finding good places to replace the income from the bonds, took a flyer in the stock market. Stocks went up with something like a baby boom guaranteeing more purchases. They liked what they saw, and held for the long term. The flip side may be as unpleasant as the upside was exhilarating. Retirees may very well sell out and put their savings back into fixed income investments. And as money comes out of the stock market, it is likely stock prices will decline from such sales.

The Problems Arising from the Tax Cuts

There will be a couple of problems arising from the tax cuts. One problem is that it will be all borrowed money. Going into the market place for more borrowing means more investor money tied up in bonds and again, less money to make stock market purchases. Thus, it will be undermining stock market momentum.

The other problem is that tax cuts will be increasing economic activity just at the point when economic activity is high. supercharging the economy. Unemployment is at 4.1%. This is the best chance workers have had in years for pay increases. The savings rate for these workers is not great, so most of that money will pour back into the economy, and this could mean a higher GDP, and higher prices. And that also increases the chances the Fed will increase rates, and that, again, will mean better fixed rates for retirees, who will take their money out of the stock market. And remember, on top of this the Fed will sell bonds and decrease the pool of cash for stock market purchases.

It Does Not Look Good for the Stock Market

Add to this the fact that in recent years mutual fund advisers have been pretty much “all in.” Free cash has been as low as 3%, so the buying power of mutual funds is low. Also, net cash flow into mutual funds has been persistently out of mutual funds. Go here to see my discussion of buying power, mutual fund net cash flow, and many other indicators just prior to the correction.

The market may be able to shrug off these early concerns, and strike a new high, but it seems that the evidence suggests that new highs may be very hard to obtain, it is fighting a strong wind.

This May Be a Moment for Gold and Blockchain

In moments of inflation, the precious metals, gold and silver, can do very well. I think that this is quite a likely possibility. The ETFs will work: GLD, IAU, SGOL. For the same reason, blockchain, the cypto-currencies, also limited-supply entities, the current darlings of the speculators, may also do well. Though not until after the current damage has run its course. Bitcoin is off 50%, but it may see some more damage before recovery. I am not recommending them yet.

Data from Robert Shiller's website; graph Mark Donnelly

The graph above dates from 1965 when the U.S. economy was stimulated by a war in Vietnam and a war on poverty. In 1974 the Arab countries decided to punish America for supporting Israel in the Yom Kippur war, and oil prices went from $3 per barrel to $12 per barrel. The S&P had a very hard time in making any progress until interest rates started to come down and inflation (CPI) had started to level off.

I have been looking for a normal cycle to return, and it appears with the jobs report this is coming into focus. Stimulus from the tax cuts and hurricane rebuilding efforts are going to make it difficult to halt Fed interest rate increases. And this will surely try the mettle of the new Fed chairman Powell, who, though experienced, comes to the job with less knowledge than the last four chairmen, all Ph.D.s with extensive educations.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.