Attempting to Divine the Biggest Surprises of 2018 - Pt. 1
"The missing step in the standard Keynesian theory [is] the explicit consideration of capitalist finance within a cyclical and speculative context . . . finance sets the pace for the economy. As recovery approaches full employment . . . soothsayers will proclaim that the business cycle has been banished [and] debts can be taken on . . . But in truth neither the boom, nor the debt deflation... and certainly not a recovery can go on forever. Each state nurtures forces that lead to its own destruction. "
--Hyman Minsky, John Maynard Keynes
Contrary to the expectations of many (including myself), the uncertainties following the surprising Trump presidential election victory, which produced a number of possible outcomes (some of them adverse), was enthusiastically embraced by investors in 2017.
After a year of historically low volatility and ever-rising stock prices, the bullish consensus was "in" and the contrary was "out" in 2017.
But after the Trump election win in late 2016, a market on steroids was not a conclusion or forecast by any main stream Wall Street forecaster. There was no sell side strategist on Wall Street who expected equities would rise anywhere near the 20%-plus gains in the major indices recorded thus far in 2017, nor do I know any who predicted that the senior average would make 70 individual highs during the year.
The biggest surprise in 2018 may be that extrapolation of the market uptrend doesn't work after many years of working, and that we will witness the emergence of multiple non-consensus developments, including a dramatic drop in the price of bitcoin (to under $2,000) and a devastating decline in many bitcoin collateral plays, a much higher oil price, a slowing (not expanding) rate of economic domestic growth as the tax bill "trickles up," not down, disappointing 2018 S&P earnings relative to consensus, a mean reversion higher in volatility and the bursting of the global short volatility bubble, which serves up a 20% drop in equities (aided by both weaker earnings results and lower valuations).
And, of course, there are many more surprises in the fertile political arena with the incalculable Orange Swan at the helm in Washington, D.C., and in his role as the "Supreme Tweeter."
As we enter the new year, the scent of"Group Stink" is thicker than ever as the uncertainties that nearly everyone saw as we entered 2017 have been replaced with acceptance and assuagement now. Indeed, it can be observed (or argued) that we end 2017 with a full-out Bull Market in Complacency in which the leading strategists, fooled last year, are extrapolating past investment market strength in the anticipation of another 7% or so advance in 2018.
Warren Buffett once observed that a bull market "is like sex. It feels best just before it ends.'" While some of us in the ursine crowd debate whether the investment orgasm has already passed, in the extreme it finally may be Minsky's Moment and year after eight years of recovery and prosperity following The Great Recession.
Here are my 15 Surprises for 2018, which will be presented in three parts. I hope you enjoy the read:
Surprise #1: President Trump's Behavior Finally Does Matter
* A Trump relative is indicted and the president pushes the system to the limits and pardons him.
* The tax reform bill becomes the sole landmark piece of legislation of his presidency.
* Attempts by the administration to reform entitlement programs in 2018 fail miserably and prove to be the last meaningful presidential initiative over the next three years.
* The president's private lawyers, led by John Dowd and Jay Sekulow, meet with the Special Counsel in late December. Though they and the president expect to get the news that the investigation is coming to an end after a series of interviews with White House personnel has been completed, they are disappointed. The president angrily tweets for several days and soon thereafter fires Robert Mueller, setting off a constitutional crisis.
* National Economic Council Chairman Gary Cohn, Commerce Secretary Wilbur Ross and Secretary of State Rex Tillerson announce they will leave the administration by Jan. 31, 2018. Later in the year, Treasury Secretary Steve Mnuchin resigns. In unprecedented fashion, the president decides not to replace the Secretary of State, saying that he, the president, already makes all the Cabinet official's decisions and sets policy/strategy.
* With domestic economic growth slowing by mid-year, Trump retaliates against China in a major trade war, serving to exacerbate the economy's slowing rate of growth.
* Amid heightened tension between the U.S. and North Korea, the Winter Olympics are canceled because few want to go to South Korea after North Korea threatens to attack it during the games. Trump bombs North Korea, North Korea responds and does serious damage to South Korea, damaging the global supply chain and crippling global trade.
* The Pee Pee Tape is released. Trump turns on Russia and Russia turns on Trump.
* A major health issue sidelines the president for weeks during 2018. Vice President Mike Pence picks up much of Trump's responsibilities. President Trump disagrees with some of Pence's decision in a series of tweets that serves to be further disruptive to the administration and leads to more resignations of senior officials.
* President Trump becomes disengaged from Washington, D.C., and becomes the first part - time president in history spending the majority of his time in New York City, Bedminster, New Jersey, and Palm Beach, Florida.
* Trump is named Man of the Year by Time Magazine in late 2018, though he refuses to be interviewed and photographed for the periodical's cover story!
Surprise #2: Politics is Upended in 2018. As the U.S. Electorate Pushes Left in Mid-Term Elections
The tax cut for the rich is election manna for the Democrats.
The U.S. economy falters next year, more due to monetary tightening, but everyone blames Trump and the ineffective tax reform initiatives put in place in late 2017 that do little to encourage capital expenditures and feather the bed of corporate executives.
With a malfunctioning and disorganized administration, almost nothing gets done in Washington, D.C.
The House falls to the Democrats in the November mid-term election, but the Senate remains barely (by one seat) in control of the Republicans.
Establishment Republicans -- seeing an intermediate and longer-term threat because of large losses in voters who are minorities, females and those under age 35 -- panic and begin to reconstitute the party's leadership toward a more youthful profile and try to expand the party's tent in order to survive the reduced support seen for the Trump administration.
House Speaker Paul Ryan, recognizing the need for party change, resigns.
Surprise #3: The Tax Bill Fails to Buoy S&P Earnings Anywhere Near Expectations of 7% to 10% Incremental Growth
Slowing global economic growth, rising inflation and interest rates (business debt now totals more than $13.5 trillion) and wage pressures (labor costs are $7 trillion) compromise corporate profit margins, offsetting nearly three-fourths of the benefit from a reduction in the corporate tax rate.
For the first time in more than five years, valuations, as seen in price-earnings (P/E) multiples, also contract.
Repatriation is a bust because many of the largest companies already have borrowed domestically against non-U.S. cash positions and, with manufacturing slack, there is little reason to expand physical plant and raise capital spending.
Most of the benefit of the reduction in corporate tax rates falls into the pockets of company executives, causing a further backlash and move of voters to the left (see Surprise #2).
Surprise #4: The Cryptocurrency Bubble Pops and Gold Makes New All-Time Highs
By means of background and as discussed previously in my Diary, bitcoin is a cryptocurrency released as open source in 2009. Bitcoin is a bearer instrument that provides a peer-to-peer exchange, allowing users to exchange bitcoin anonymously based on a trusted blockchain public ledger that does not rely on a trusted third party.I have recently written several columns about bitcoin:
* Woodstock or Bitcoin?
* Boca Biff Does Bitcoin
* Why Bitcoin Is En Fuego and Where It Might Go From Here
My Surprise is that though bitcoin becomes ever-more popular over the near term and rises to more than $21,000, the price plummets to under $2,000 during 2018.
The publication of this surprise -- that bitcoin will collapse in price in 2018 -- results in growing public criticism on Twitter and elsewhere from bitcoin devotees over the next few weeks toward me. I am called a "no coiner," a term given to bitcoin disbelievers such as myself. "No coiners" are defined as people who missed out on the rise in the price of bitcoin and have become skeptical and bitter, and who state that it's only a matter of time before the price collapses because it's a collective delusion.
In early 2018 the popularity of cryptocurrencies such as bitcoin crests. Bitcoin ATMs even become commonplace in Boca Raton, Florida, reminding us of the historic relationship between that town and past frauds and schemes. (Boca Raton has been the home of so many fraudulent schemes -- currency trading schemes, rare coin scams and the sale of timeshares for fictitious vacation homes. Former Securities and Exchange Commission Chairman Richard Breedenfamously said that Boca Raton is "the only coastal town in Florida where there are more sharks on land than in the water.")
My surprise is that bitcoin trades above my target of $21,119 by early January but crashes in 2018 to under $2,000 and falls toward and eventually below the cost of mining the cryptocurrency, which today is about $1,000 to $1,500.
The initial pause and sizable break lower in bitcoin's price is when market participants begin to realize more fully that the supply of cryptocurrencies, in the aggregate, is unlimited with low entry barriers. The threat and realization of this risk is prompted by Apple Inc. (AAPL) and Amazon.com Inc. (AMZN) , which introduce their own easy-to-use and faster cryptocurrency blockchains. (Note: Amazon already has received a patent for its own blockchain technology -- 8,719,131 -- see here and here.)
JPMorgan Chase & Co. (JPM) causes a stir after CEO Jamie Dimon's previously negative comments on bitcoin by introducing "JPMorgan E-cash," its own cryptocurrency. Soon thereafter, other banks follow suit. As well, several governments (including the U.S.) introduce their own government-based cryptocurrencies based on their desire to continue to control policy levers such as money supply and fiscal policy.
The eventual demise for bitcoin commences in earnest when it is revealed in a New York Times expose that less than 10 entities, mostly residing in China and Japan, are found to have manipulated the price of bitcoins higher in Ponzi-scheme fashion over the last two years. The cryptocurrency bubble finally collapses in dramatic fashion and falls in value by 90% as a result of direct government intervention and a successful hacking where thieves penetrate the blockchain code and steal a large amount of coins.
Several large, well-known hedge funds desperate for "alpha" are caught with their pants and portfolios down and with a large weighting in bitcoins and other cryptocurrencies; they lose more than 30% of their funds' assets and value and are forced to liquidate their cryptocurrency holdings and close their funds.
Bitcoin will ultimately assume a permanent place in the Speculative Hall of Fame, along with tulips (1636-37), the dot.com bust (1999-2000), the housing bubble (2005-07) and the South Sea Bubble (1711-20), as traders and investors learn the lesson, once again, that an asset class founded on the notion that there is a greater fool who will be willing to buy that asset for more than the previous fool paid, almost always ends in disaster.
The year 2018 will be one in which investors come to understand that blockchain technology -- a distributed database of records of transactions that are executed and shared among participating parties and are validated by a network of users, called "miners," who contribute computing power in exchange for the chance to garner coins using a shared database and distributed processing -- is real (each transaction is encrypted and can't be replicated or altered), but that bitcoin is a mirage and becomes, like many past schemes, a byword for Ponzi-like nostalgia.
Interest in gold, which has been sidelined for months amid the cryptocurrency frenzy, regains popularity, reverses direction from the lower left to the upper right and moves higher in price.
In an abrupt and swift flight to alternativesafety, gold makes new all-time highs and becomes the single best-performing asset class in 2018.
Surprise #5: The S&P Index Roars Into the 2017 Close and Makes a 2018 High on Jan. 2, 2018
Optimism about the U.S. economy and 2018 S&P earnings result in an all-time high in the MSCI World Stock Index by the close of 2017. For the first time ever the index posts a total return in every single month in 2017, hitting a remarkable sequence of 14 months of positive returns.
However, at the same time, the European markets mid-September stall continues and Europe begins to perform poorly both in an absolute and relative sense late in December, 2017. This geographic divergence initially is ignored but proves to be an important signpost of a January market top in the U.S.
Despite reducing the corporate tax rate from 35% to 21%, the benefit from the new tax bill is not anywhere near expected because actual corporate tax rates are significantly below the 35% statutory rate and already under 25%.
Because median stock valuations rarely have been higher both on a GAAP basis and on a forward P/E and enterprise value to EBITDA (EV/EBITDA) basis, it turns out the late 2017 stock surge overshoots and more than discounts the benefit of the tax bill.
Equities steadily decline in 2018.
Dip buying is not rewarded, but shorting the rips is rewarded next year.