A Crossroad For 2018

Most of the uncertainty about 2017 has been about what major legislative changes will take place and it looks as though we will get a change to tax policy as the Senate passed its tax bill late Friday night. Love it or hate it we will likely see it passed this coming week. For the tax bill to work as planned, we will need to see continued GDP growth of 3%+ and a reduction in government expenditures in the coming years. At least we have some certainty now, however, the repeal of the individual mandate from Obamacare was not in the House bill so that may be the wildcard during the reconciliation process between the House and the Senate. If push comes to shove, I think the Senate drops the repeal but I don’t assign a high probability to that outcome.

What we care about for purposes of the financial markets is the reaction to this news. Sometimes good news is met with lower prices as markets front-run the outcome and book their profits once the event has occurred (selling the news). Over the past week there has been a noticeable increase in intra-day volatility which portends that the market is nervous about next week’s outcome.

So let’s consider two scenarios that may play out over the next several weeks or months. One good, one bad.

The Bad: Earnings have been good but they are relatively unchanged to 2015 and the stock market continues to rise higher – an “overvalued” condition. The “good” news from policy changes are priced in and we are in for a sizable correction. The market leaders for 2017 (technology and semi-conductors) have run out of steam these past several weeks which indicates the market has lost momentum and needs to test lower prices to bring in new buyers. This would likely mean the indices fall enough to create a panic (10% or so). It wouldn’t be hard to create a panic given the high level of complacency and low volatility. There are indications of chasing prices higher and over optimism as anything related to bitcoin rips to newer prices just like the dot-com craze in the late 1990s.

NASDAQ
$QQQ

The Good: Tax legislation passes and the market rotates sector leadership – heavily. This would mean a change of leadership into the hands of small caps stocks in the Russell 2000 and financials as they benefit the most from tax policy, regulatory changes, GDP growth and higher interest rates.

The Russell 2000 is an all domestic index that went sideways for a large portion of 2017 so  it could play catch-up with the NASDAQ and S&P 500 as the benefits of lower taxes and regulatory hurdles benefit the bottom line .

$IWM

Financials have been laggards for years as the $XLF (financials) ETF has yet to recover its May 2007 high and would benefit immensely from a growing economy and higher interest rates as expected from the Federal Reserve.

$XLF

There is a combination scenario where we get a large-pullback like we did at the end of 2015 that re-sets the market for another year of rally with new market leadership. It is times like this that liquidity is best as it gives the most flexibility to re-position without too much pain. The outlook for 2018 could be set in the next several trading sessions so watch the reaction of the stock market after the tax legislation passes this week. If it doesn’t pass for whatever reason, then I would expect a sharp move lower.

 

Chart of the Week

Where is North Korea on the map? The answer of each respondent is represented by a blue dot.

Where is #NorthKorea?

 

Economic & Central Banking Snippets

  • The Bank of England is forcing UK banks to hold an extra £6B in capital to guard against risks after Brexit, as it called on the UK and the European Union to introduce legislation to avoid a crisis in derivatives and insurance markets. The aim is for lenders to better withstand against “material” macroeconomic risks beyond Brexit, such as global debt levels, asset valuations and misconduct costs. The buffer could raise again next year, the central bank warned.
  • In the latest report released by Adobe, Cyber Monday hit record revenues of $6.59B, making it the largest U.S. online sales day ever. In comparison, Black Friday and Thanksgiving Day brought in $5.03B and $2.87B respectively. The internet holiday shopping season has so far (Nov. 1-27) driven a total of $50B in revenue, a 16.8% increase, and Adobe predicts it will be the first-ever season to break $100B in online sales.
  • The US economy expanded at its quickest pace since 2014 in Q3 as GDP climbed at an annualized rate of 3.3% over the period.
  • A forward looking indicator of US home sales rebounded last month driven by the southern part of the country, which saw strong growth after hurricane-related disruptions in September.
  • The velocity of money appears to be near a bottom. A harbinger for higher inflation? (WSJ) This possible if GDP growth moves higher and the money supply tightens due to higher interest rates.
Velocity of M2
  • Japan’s manufacturing sector expanded at a solid rate in November with conditions in the market showing the strongest improvement since March 2014, according to an industry gauge. The Nikkei-Market Japan manufacturing purchasing managers’ index rose to 53.8 in November from 52.8 in October and remaining well above the 50-point level separating expansion and contraction. Underpinned by strong demand from overseas, new orders placed with Japanese manufacturers increased at the most marked pace in 44 months in November.
  • Here is how Bitcoin compares to other recent financial bubbles. (WSJ)
Bitcoin
  • Natural gas has overtaken coal as the dominant fuel for electricity production.
Coal Dethroned

 

Market Snippets

  • SoftBank Group has told stakeholders in Uber Technologies that it will initially offer to buy shares at a nearly 30% discount to the company’s most recent valuation of $68 billion! (FT)
  • Two of the world’s largest futures exchanges, CME Group and CBOE Global Markets, have been given a regulatory green light to list bitcoin futures, a significant step in allowing mainstream investors to buy and sell the highly volatile cryptocurrency. Market players will be able to short bitcoin – will that stop the move higher?

 

International Snippets

  • Royal Bank of Scotland has closed the “bad bank” it created to handle a vast pile of toxic assets after the financial crisis nine years ago, having racked up cumulative losses of over £50B from the unit.
  • The world’s biggest oil producers have agreed to extend a deal to curb oil production throughout 2018 in an effort to shrink swollen stockpiles and keep prices above $60 a barrel. Saudi Arabia and Russia, whose combined production makes up a fifth of global supplies, led the effort by 24 countries inside and outside Opec. (FT)
  • World’s biggest battery switches on The world’s biggest lithium-ion battery has begun dispatching power into Australia’s energy grid. It has the capacity to supply 30,000 homes for one hour, which is three times as powerful as any other batteries currently installed. The system was an audacious promise by Tesla’s Elon Musk, who said he could build it within 100 days or he would provide it for free. He won. (FT)

Learn more about the author here.

Paul McCarthy

Mr. McCarthy is the President and founder of Kisco Capital.