Weighing the Odds for the Markets in 2018

As I’ve mentioned for the past few days, the only thing driving this market higher has been the prospect of US tax cuts. Overnight, the process took another step towards becoming reality. From the Financial Times:

Republicans have passed their landmark tax bill in the House of Representatives, leaving the legislation just one round of voting away from being sent to President Donald Trump to be signed into law.

The bill, which was finalised last week and promises a $1.5tn tax cut, passed the GOP-controlled House by a margin of 227 to 203 with Democrats voting in unison against the bill. Twelve Republicans voted against it.

The bill now moves to a vote scheduled for Tuesday evening in the Senate, where Republicans have a far slimmer majority and need the votes of 50 of their 52 senators to pass the bill.

The stock market sold off on the news. Which is not surprising. There is no longer the ‘anticipation’ of tax cuts. They’re pretty much in the bag. Let’s see whether the sell-off continues as the ‘buy the rumour, sell the fact’ trade plays out.

Whatever you think of the morality of the tax cut, there is no doubt that it will provide an economic boost. It will effectively inject US$1.5 trillion into the US economy. But instead of it being wasteful, government directed spending, the additional funds will end up in the pockets of businesses and households.

This will ensure a more efficient allocation of resources, which should in turn lead to productivity improvements. Productivity is the main long term driver of economic growth.

But there is a cost. And that is a US$1.5 trillion increase in US government debt. It might not be an issue now, but when the business cycle turns it will come back to bite.

Which begs the question, when will the business cycle turn down?

No one can accurately predict that. But you can keep your eye on the ‘US yield curve’ for clues. This has been the best recession indicator over the past few decades.

As this article from Bloomberg explains…

The chart below shows that every recession since the mid-1970s (the shaded regions) has followed an inverted yield curve when the two-year note yields more than the 10-year:

10 Year Treasury constant maturity minus 2 year treasury constant maturity 20-12-2017


Source: Federal Reserve of St Louis
[Click to enlarge]

The spread has been rapidly closing in recent years and is fast approaching another inversion. Since September alone, the two-year yield has gone from 1.26 percent to 1.85 percent. In that same time, the 10-year yield has gone from 2.05 percent to 2.37 percent. This means the yield curve is getting “flatter” as long-term rates are rising much slower than short-term rates.

It’s important not to jump the gun here. The curve is still some way from being inverted. And it was a lot closer in 1995. Yet we didn’t get a recession until 2001.

But if the Fed continues to raise short term rates in 2018, and the 10 year bond market thinks those rate rises will dull credit growth and therefore economic growth, then yes, the yield curve will continue to head towards zero. 

Let me show you another chart. It shows the Fed funds rate since the mid-1950s, with the shaded areas indicating recession.

What you see is that Fed rate rises preceded every single recession. If the Fed continues to raise rates in 2018, especially in the absence of a pick-up in inflation, meaning real rates are rising, then it increases the odds of a recession hitting sometime in 2019.

Effective Federal Funds Rate 20-12-2017


Source: Federal Reserve of St Louis
[Click to enlarge]

It’s something to watch out for. But I don’t see the point in getting too dogmatic about it. Let’s just see what happens.

Assessing the future is all about weighing up the odds. We can never be sure of how the future will unfold. So I talk in probabilities, never in certainties. With interest rates rising in the US, and with the post-2009 economic expansion being one of the longest on record, there is an increasing probability that the business cycle will soon start to turn down.

Speaking of probabilities, there is a much higher probability that you’ll see a bitcoin bust in 2018. The price appreciation this year (see chart below) just defies all logic.

Bitcoin / USD | 1 day bar chart 20-12-2017


Source: Optuma
[Click to enlarge]

It’s a pure speculative bubble. And this, from the Financial Times, has a real dot-com flavour to it…

US regulators have halted trading in shares of Crypto Company, a penny stock whose value surged more than 2,000 per cent this month thanks to the hype surrounding bitcoin, saying it was concerned over the possibility of market manipulation.

Crypto, a Malibu, California-based business that says it is building a cryptocurrency trading and advisory business, was one of a handful of previously obscure stocks to have drawn attention for wild price moves, as investors hunted for equities that might benefit from the booming interest in digital currency.

If you’re punting only a small portion of your capital on bitcoin, that’s fine. But if you’re all in, thinking that ongoing price rises will deliver you the retirement of your dreams…then I think you’re in a spot of bother.

Who knows whether Bitcoin will enjoy another leg up? I have had, and continue to have, no idea about its short term price direction.

But coming back to probabilities, I think it’s much more probable that bitcoin will go down in 2018 than up.

On that note, as this is my last Money Morning for the year, I wish you all a Merry Christmas and a Happy New Year. See you back here in 2018.

Regards,

Greg Canavan,
Editor, Crisis & Opportunity


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

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