10/8/18

Four Horsemen of the Stockalypse

On October 3, 2018, the Dow Jones Industrial Average hit an all-time, history of the world, high of 26,951.81. There are four, existential threats to US stocks. Let us call them the four horsemen of the stockalypse.  


Four existential threats to the stock market



Four existential threats to the economy and the stock market (with subjective probabilities):


1. The Fed Raises Rates (90+%)
2. Impeachment (75% chance Dems win House)
3. Trade Wars (90+%)
4. The Market Raises Rates (100%)

Any one of these issues could cause a recession and a stock market decline. The fact that each of the four is likely at the same time is simply amazing.


1. The Fed Raises Rates (90+%)

In August of 2016, Janet Yellen told the world that the Fed would raise rates. Specifically, she said somewhere between 12 and 20, quarter point rate increases. So far the Fed had done 8 of these raises, and the world is starting to listen to the Fed (chair Jerome Powell said last week that the Fed is a long way from neutral.)

Here is the article I wrote in 2016 on the Fed (click: "The Yellen Collar"), and here is the cartoon I had drawn at the time.


John Maynard Keynes famously wrote, that "markets can remain irrational for longer that an investor can remain solvent." In October of 2018, the financial markets are reacting to news from 2016.

Anyone who could read could have known that the Fed was going to hike rates. The harder challenge, and the one that matters for investing, is figuring out when the herd is going to understand the news.

2. Impeachment (75% chance Dems win House)

Nate Silver of fivethirtyeight.com estimates a 75% change that Democrats win the house:

As with Fed policy, what is amazing is that the election is next month! Impeachment by a Democratic house is a possibility. Resistance to President's Trump economic policy is a certainty.

3. Trade Wars
Here are four possible outcomes of the Trade conflict with China.

a) China yields.
b) President Trump yields.
c) President Trump accepts a modest change and declares victory as he did with NAFTA.
d) Long and costly trade conflict with China. (<- CHICKEN LITTLE predicts)

Outcome (a) has a close to zero probability. Here is a photo of Chairman Mao from the Long March:

China is willing to endure pain to win

Outcome (b) also has a zero chance. Outcome (c) is a fake victory for the US similar to the victory with Mexico and Canada. The new NAFTA will not have any first-order impact on the US economy.

Will President Trump fold with China? I don't think so (and I am not saying that he should fold). President Trump has filled his staff with China trade hawks (e.g, Peter Navarro, author of "Death by China".)

So a HUGE trade war with CHINA is significant possibility. Trade Wars played a significant role in the 1930s Global Depression.




4. The Market Raises Rates (100%)

What about the Greenspan put? Ever since 1987, the Fed has watched the stock market, and has always acted to support stock prices. The Fed's official mandate is stable prices and full employment. The unofficial mandate is make sure that the cheap money bubble does not deflate.

Under the Greenspan put, the Fed will switch from raising rates to lowering interest rates if something bad happens to the economy. Under current Fed policy, "heads the speculator wins, tails the Fed uses your money to bail out the speculator."

This "Greenspan Put" has worked to reward imprudent risk-taking for 31 years. What is different now? The answer is Debt and Deficit.

The US Federal Government deficit is approaching a trillion dollars a year. This deficit exists in an environment of solid economic growth, low interest rates on government debt (which restrains the deficit), and an unemployment rate of 3.7%.


The US Federal Deficit and Debt will balloon further during the next recession. As interest rates on US debt rise, a negative feedback loop will ensue where higher interest rates lead to larger budget deficits, which lead to higher interest rates.

Even when the Fed moves to cut rates, the market will raise rates. The Fed is powerful; market panic and pandemonium are more powerful.

***
Has the stock market priced in these risks? No. We sit less than 2% from an all-time high in the Dow, priced for perfection on the precipice of ruin.




Ignore the four horsemen of the stockalypse at your own peril.


October 8, 2018 
Dow Jones Industrial Average: 26,486.78

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