Time to Reduce Exposure to the Stock Market

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Dear Reader,

The major stock market indices will move sideways through the remainder of the month (and year) to end the year about where they are now. That said, if markets move outside a narrow range, there is more downside potential than upside.

This is a good time to lighten up on equity exposure and reallocate to bonds, cash and gold.

Stock markets haven’t gained much over the past two years. That may come as a shock to investors who feel like they’ve been on a roller coaster ride since early 2018. Yet, the fact is that the Dow Jones Industrial Index was 26,616 on January 26, 2018 and about 27,850 as of today.

That’s about a 1,200-point gain, or 600 points a year. 600 points is one good day for the market. Is that the best it can do over two years? Even adding an average 2% annual dividend yield, the annualized return is about 3%. That’s far less than an investor could have made in super-safe U.S. Treasury bonds.

If you’re a day trader, you might have made money buying dips and selling near the top in rallies. More likely, non-professional traders lost money chasing the rallies and bailing out during the drawdowns. If you’re the typical buy-and-hold investor watching your 401(k) statements, you’ve gone almost nowhere despite the fireworks. You’re right back where you started.

The question is, why?

The drivers of the sideways movement in stocks are slow economic growth and weak earnings growth in individual companies.The drivers of the short-term volatility along the way are good news/bad news on trade wars, and utter confusion at the Fed.

The bottom line is stocks are moving sideways on a sea of uncertainty. Let’s back up a minute to see how we got here…

After the Trump tax cuts passed in late 2017, the White House was predicting growth would return to the long-term trend (post-1980) of 3.2% or higher. That hasn’t happened.

The second quarter of 2018 did show annualized growth of 3.5%, but that was a one-time effect from employee bonuses and consumer confidence due to higher stock prices resulting from the Trump tax cuts.

That euphoria quickly faded.

Growth in the fourth quarter of 2018 was only 1.1%. For all of 2018, U.S. GDP grew by 2.9%, higher than the average growth since the end of the last recession in June 2009, but far less than the White House projected.

Since then growth has slowed even more as the effect of the 2017 tax cuts has faded. On an annualized based, the first quarter of 2019 showed 3.1% growth, the second quarter was 2.0% and original readings of third-quarter growth came in at 1.9%. It was upgraded to 2.1%, but that’s nothing to write home about.

This puts annualized growth year-to-date at 2.4%, almost exactly where it has been for the past ten years. In short, the Trump growth miracle is a mirage. We’re in the same 2.3% rut we’ve been in since 2009.

The cumulative impact of trade wars, currency wars and geopolitical tension is also reflected in a slowdown in global growth. The following summary comes from the IMF’s World Economic Outlook press conference on October 15, 2019 as presented by Gita Gopinath, Director of the IMF’s Research Department:

As for the global economy, the global economy is in a synchronized slowdown. And we are, once again, downgrading growth for 2019 to 3 percent, its slowest pace since the global financial crisis. Growth continues to be weakened by rising trade barriers and growing geopolitical tensions. We estimate that the U.S.‑China trade tensions will cumulatively reduce the level of global GDP by 0.8 percent by 2020. Growth is also being weighed down by country‑specific factors in several emerging market and developing economies and also by structural forces, such as low productivity growth and ageing demographics in advanced economies. … The weakness in growth is driven by a sharp deterioration in manufacturing and global trade, with higher tariffs and prolonged trade policy uncertainty damaging investment and demand for capital goods… Overall, trade volume growth in the first half of 2019 has fallen to 1 percent, the weakest level since 2012.

The good news/bad news volatility is also easy to explain. Stock markets are no longer traded by humans with different perspectives. Stocks are traded by robots, and robots are dumb.

Many investors still have the belief that their buy or sell stock orders are matched against other orders by humans with different views. The orders are matched by computers and the result is an orderly market with efficient price discovery. That scenario is not true.

Today, over 95% of New York Stock Exchange trades are generated by robots using algorithms to decide when to buy and sell. These are not matching systems (which have been around since the 1990s). These are trading robots that decide what to do without human intervention.

Trading is no longer man v. man or woman v. woman. It’s robot v. robot with a small number of trades in the form of man or woman v. robot. You’re not trying to outwit another human. You’re trying to outwit a robot.

The good news is that robots are easy to figure out. They act automatically based on source code and algorithms developed by coders and applied mathematicians who don’t necessarily know much about the psychology of markets. Robots buy or sell based on headlines or key words.

They also buy “high” (as defined) and sell “low” (also as defined) based on boundaries set by the developers.

This dynamic explains both the short-term volatility and the longer-term range bound trading. On the one hand, robots will scramble (in microseconds) to dump stocks if there’s a negative report in the trade wars.

They likewise buy stocks if there’s a positive report in the trade wars. At the same, robots will sell when stocks approach Dow 27,000 (or similar benchmarks on the S&P 500) and buy when stocks approach Dow 25,000.

Unfortunately, neither the robots nor their human developers were ready for the Age of Trump.

President Trump will call President Xi of China his “best friend” on Monday and denounce Chinese “theft” on a Wednesday. Robots are good at reading headlines, but they’re no good at understanding nuance, body language or Trump’s Art of the Deal style.

The same is true of the robots’ ability to understand the Fed.

Jay Powell was a hawk in December 2018 (when he raised rates), a dove in January 2019 (when he promised not to raise rates), a super-dove in the spring of 2019 when he decided to cut rates and end Fed balance sheet reductions, and utterly confused in September 2019 when he said he might not cut rates soon, but would expand the balance sheet. Then Powell cut rates again in October.

How is a robot supposed to understand a highly conflicted human? It can’t. But, it can issue automated buy and sell orders on every new headline.

The bottom line is that growth is weakening, the Fed is cutting rates, the trade wars are not over (despite happy talk) and political tensions are rising.

That’s a mix of support for stocks (Fed rate cuts and good trade war news) and headwinds for stocks (bad trade war news, weak growth and politics). These forces will tend to offset each other and leave stocks in early 2020 about where they are now.

That’s a reason to reduce equity exposure and consider some of the stronger plays in bonds and gold.


Jim Rickards
for The Daily Reckoning

The post Time to Reduce Exposure to the Stock Market appeared first on Daily Reckoning.

Wall Street and the New Cold War

This post Wall Street and the New Cold War appeared first on Daily Reckoning.

The stock market seems to rise or fall almost daily based on the latest news from the front lines of the trade wars.

When Trump threatens new tariffs and China threatens to retaliate in kind, stocks fall. When Trump delays the tariffs and China agrees to resume negotiations, stocks rise. And so it goes. It has been this way since January 2018 when the trade war began.

The latest dust-up came late last week when Trump threatened tariffs against Mexico if it doesn’t do more to curb illegal immigration to the U.S. Markets sold off on Friday as a result, bringing a terrible May to an end. Largely due to the trade war, the stock market had its worst May in seven years.

From the start, Wall Street underestimated the impact of the trade war. First they said Trump was bluffing. Then the analysts said that Trump and Xi would put their differences aside and make an historic deal.

All of these analyses were wrong. The trade war was problematic from the start and is growing worse today.

China will lose the trade war. The reasons are obvious. Foreign trade is a much larger percentage of Chinese GDP than it is for the U.S., so a trade war was always bound to have more impact on China than the U.S.

And if China tries to match the U.S. in tariffs dollar for dollar, they run out of headroom at $150 billion while the U.S. can keep going up to $500 billion and inflict far more pain on China.

Other forms of Chinese retaliation are mostly nonstarters. They cannot dump U.S. Treasuries without hurting their own reserve position and risking an account freeze by the U.S. China cannot turn up the pressure by stealing intellectual property because they’re already doing that to the greatest extent possible.

China’s latest threat is to ban exports of “rare earths” to the U.S. and its allies. Rare earths are essential for the production of plasma screens, fiber optics, lasers and other high-tech applications. Electric vehicles, mobile phones and telecommunications systems would be impossible to build without them. China is responsible for 90% of global production, which makes them a potent weapon in the U.S.-China trade wars.

“Rare” earths aren’t actually that rare. They are plentiful in quantity. The problem is that they are found in extremely low concentrations. This means a huge amount of ore and expensive mining processes are needed to extract even a small amount of these vital substances.

So rare earths are one weapon China possesses.

But over time, Western powers can replace rare earths purchased from China. There could be major manufacturing disruption in the meantime, it’s true. But it would not be the end of the world.

The U.S. will win the trade war and either China will open its markets and buy more U.S. goods or the Chinese economy will slow significantly.

But while the trade war is important, it’s not the main event.

The trade war is part of a much larger struggle between China and the U.S. for hegemony in Asia and the Western Pacific.

They are locked in a new cold war being fought on many fronts. These include trade; technology; rights of passage in the Taiwan Strait and the South China Sea; and alliances in South Asia, where China’s Belt and Road Initiative is promising billions of dollars for infrastructure development.

The U.S. is responding with arms deals and bilateral trade deals to counter Chinese influence. Even if a modest trade deal is worked out with China this summer, it will not put an end to the larger struggle now underway.

What are the implications?

If the Chinese view the trade war as just one step in a protracted cold war, which I believe they do, then we’re in for a long period of contracting growth that will not be confined to China but will affect the entire world.

That seems the most likely outcome for now. Get set for slower growth and perhaps stagflation. It could be like the late 1970s all over again.

Slowly, Wall Street is taking the trade wars seriously. But it is still missing its larger implications of a new cold war.

This new cold war could last for decades and it will affect the entire global economy. Let’s just hope it doesn’t turn into a shooting war.

Below, I show you why it could. Read on.


Jim Rickards
for The Daily Reckoning

The post Wall Street and the New Cold War appeared first on Daily Reckoning.