ASSumptions

Posted by: Michael Williams on Tuesday, June 28, 2016

Courtesy of wikipedia Oscar Wilde said, “When you assume, you make an ass out of u and me.” Which is probably one of the most astute observations of the human condition and I might add put in an eloquent, yet poignant way. The run-up and fall-out of the BREXIT has validated Wilde’s famous quote, much of it has been political/media spin doctoring from the Statism class. Unfortunately our youth, which I “assume” is true for all ages, can’t be bothered with educating themselves and would rather be emotionally driven by headlines and empty rhetoric. All the excitement over the BREXIT has not only rocked the markets, but has reminded investors how fragile the markets can be – if only driven by perception based on assumptions.

ASSumptions

The recent rally and sell-off in the markets have been driven solely on assumptions, for a vote not cast and even a vote taken is not policy. Investors and traders rushed into the markets as they assumed the vote would be for “staying” in the EU and then in full-rout exited bruised and dismayed. Yet the irony is that nothing, not a single change in policy, government, status, trade, or anything has yet happened nor will it for a while. The entire rally and sell-off was based solely on assumptions. We must separate fact from fiction and it is unfortunate that political rhetoric, echoed by bias media, and then ignorant celebrities is more subjective assumptions not based in reason or logic, than actual fact. The day after the vote I posted an article, which tried to separate these facts from fiction – but I continued to receive a deluge of “what is going on?”, “should I buy or sell”, “is the market going to crash”.
Britain The nation of Britain is certainly an important one, but it is not the end-all and be-all in a broad economic sense. Those days ended when the sun finally set on the English Empire. The vote has certainly been cast to exit the EU, but Britain hasn’t left and there remains questions as to when, how and even if. No one knows for sure how it will actually disrupt trade and currency in the long term, but one can make some logical and reasonable observations, hopefully devoid of the subjective silliness that seems pervasive in the bias media. Courtesy of wikipedia We know that trade will continue and so will immigration. The question, as investors, we should ask is who will fair better, the UK or the EU. I think it would stand to reason that the UK certainly has a better opportunity, in so far as the government (and forces that be) position the UK in a competitive and attractive fashion for business. Simply put, the UK now has the ability to set their own agenda when it comes to predominately trade and monetary policy. The UK had always positioned themselves, like a few other EU members NOT to adopted the Euro (dollar) and be beholden to the full monetary whims of the ECB. That helps give them an easy exit, as it does others that maintained their own currencies. Immigration Hate Train True, the primary driver that created voter turnout was immigration. Unfortunately the message was muddied by politics and press, which created more confusion and ignorance over the difference between immigration and refugee (asylum seekers) that fall under the CAES rules of the EU. Certainly the wave of Middle Eastern (primarily Syria) refugees, coupled with the rise in terrorism in France and Belgium has driven up concerns in all the EU nations. No nation wants to be dictated on how to handle refugees, that has obviously brought with it a potential possibility of terrorism or at least contentious integration. Not to mention the cost in both time, money, and even value that impacts the citizens of a nation. Let me segue for a second to a personal experience that may bring forth some better understanding. When I lived IN San Francisco (Upper Haight), I frequently had homeless people sleeping and defecating on my steps and in front of my house. A friend of mine, who did NOT live in the city, was a huge advocate to help the homeless, feed them, and give them more freedom to pretty much live and do what they want. She would argue – they are people too, they should be able to live and do what they want. It was easy for her to expound these views because she lived in a beautiful suburb, with no homeless, and she commuted into the city and left. She didn’t have to step over them out her front door or wash away the urine smell. I appreciated her view, but I can’t help wonder how she would feel if she lived in my house having to see it, smell it, and deal with it on a daily basis. There was certainly a fight as the people living and dealing with it in the city wanted it addressed vs. those that didn’t live in the city that “seemed” far more compassionate. Thankfully the mayor at the time took action, to my friend's chagrin. The situation is similar in the EU when dealing with the refugees. People want to help, as long as it is not in their town or in their nation. We had a similar situation with GITMO, what state would take the prisoners from GITMO? Many people wanted to close GITMO, but they also didn’t want the prisoners coming to their state.
Loosing Site Yet for all the refugee or mischaracterized immigration issues in the EU, which will be dealt with regardless of EU nation status, the issues that impact the rest of the world (outside of the EU) are trade and currencies – PERIOD. Trade Britain is the world’s 9th largest exporter ($472b) and 5th largest importer ($663b), when measured against 220 nations worldwide. While the BREXIT will most likely not change those figures by any significant measure, we should ask WHY they would change. The WHY question is far more important than the HOW. The only reason exports and imports changes is based on supply and demand. We know a BREXIT will not change the demographics of the UK or the EU significantly as to change the net supply and demand from basic consumption level. The fact is a swarm of people are not going to migrate in or out of the UK enough to make a radical difference. Yet, there is a possibility of a change in the export and imports and that is driven by cost vs. competition. Fair vs. Free What we don’t know is how the UK will position their trade in so far as how it will impact tariffs, taxes, fees, fines, and VAT. Does the UK take on a “fair trade” (protectionism) position that will drive up import costs, while subsidizing domestic businesses in some contorted effort to protect jobs and revitalize the economy after the BREXIT? Or will the UK take on a more “free trade” (competitive) stance to drive down export prices and increase trade, by lowering tariffs/duty/fees/VAT/fines? That of course will be dependent on the new government. Courtesy of wikipedia Those that support “Fair Trade”, with the use of tariffs, protectionism, subsidies, fees and fines will bring forth a trade war. There is a sweeping socialist movement in Europe and also on our shores. Protectionism is also ringing loudly in conservative circles, including Trump in the US. Ironically (and in my humble opinion, unfortunately) Trump and Sanders were very much alike when it came to Trade. We can only hope that the UK doesn’t take that path – as it will hurt the EU and other trading partners. And while it will seemingly help the UK in the short-term, it will eventually create significant and deeply long-term problems. These changes and the course that the UK takes will not happen tomorrow and certainly bring future unknowns to the table. As I previously said, if they move to a more “Free Trade” position I think it will be a boom for the UK, while a determent to the EU.
Currency The dollar rallied and the pound collapsed, panic moves in currencies can create waves through all kinds of markets. Three major impacts are debt financing, investment, and trade. A huge opposing move between two currencies can have serious repercussions. Imagine if you borrowed money from one nation, converted it to your own currency and then the other nations currency moved higher (yours fell) dramatically. While the interest hasn’t change, the cost of your payments could be tremendous as you now have to pay back your debt in that foreign currency that has significantly appreciated. You may not have enough and could default. The opposite is true as well, if you borrowed from nation in which their currency took a rapid depreciation, it would be a huge advantage to you as you could either pay off more of the debt or make lower payments (after the currency conversion). What many in the media fail to realize is that massive currency changes impact trade, investment, and debt potentially far more than trade agreements. It also impacts them TODAY and not tomorrow. Courtesy of wikipedia The only REAL impact the BREXIT vote has had, so far, is on currency exchange rates and how that trickles over to trade, investment and debt. Imagine if you are a real estate investor, perhaps building a hotel, building, or residential. You are from the EU or the States looking to build in the UK. The pound collapses against your currency, now might be the time to rush into the UK and start building as it will be cheap to do so (converting your currency to theirs). However, if you are in the UK and hold pounds and are looking to invest abroad, the huge drop in the pound will make foreign investments look extremely expensive. Currency fluctuations also help travel and tourism. Those visiting London and the UK will see a huge discount as they convert their currency to pounds. I have heard from friends already who are now considering a visit to London. My close friend from the states pays for her apartment in London on a 6 month basis, the recent collapse in the pound has conveniently coincided with her apartment payment and she is getting a nice discount. It also impacts imports, as shop owners who have to import goods will now find them expensive and for those in the UK could see currency inflation on certain imported items. While exporters in the UK may see a boom in their products as foreign nations want to import goods from the UK. As you can see currency fluctuation can have not only immediate but drastic impacts on all sectors of an economy, especially if that economy is heavily reliant on trade. As previously pointed out the UK is in the top 10 in both exports and imports, so it is a trade heavy reliant nation and thus sensitive to currency changes.
Markets It would be reasonable, after reviewing what actually impacts the economy and what doesn’t, that the currency volatility translates quickly into the markets. It is important to remember the equity markets have a tremendous amount of margin associated with it. Margin is really just another fancy word for loan. If a loan is collateralized by a fluctuating asset, like equities, it is easy for that loan to get called. In the financial markets loans get called very quickly (same day). When the market declines quickly it can trigger “margin calls” (loans being called in), which creates more FORCED selling pressure and this can feed on itself very quickly. If we look at margin debt change on a day-to-day basis (Friday and Monday) we see a huge decrease in margin. It is not difficult to surmise there was a lot of margin selling and/or margin calls. I personally translate heavy margin selling days into an over-sold market condition. Remember, when there are margin selling or margin calls, it has nothing to do with market perception and everything to do with a loan being called. The actual value of the company means nothing when it is being sold because of a margin. So in days like Monday and Friday, you see the proverbial baby being tossed out with the bath water or to clearly define it – good companies selling off because people don’t have the money to carry the stock on margin anymore and are forced to sell. As we can’t confuse margin selling days as a bear market, we also should not confuse bouncing rallies after margin sales a bull market. As far as broad economic fundamentals nothing has changed, even with a BREXIT. Sure some currency moves have, in the short-term, created some massive moves in the supply & demand of order flow – but beyond that – from an economic point, nothing has changed and nothing should be changing in the near term.
Stagnant World Growth In the most broadest sense of the terms and of course removing any/all government subsidies, aid, QE, easy monetary policies, and inflationary policies – the world economies have slowed down. Here is the simple and clear explanation why. Growth comes in TWO simple forms: New products/services and Existing product/services. In first world economies growth has slowed significantly because the vast majority of products and services have already saturated the market. Everyone has car, smart phone, TV, fridge, house, etc. Growth in these items only come two ways; replacement value and birth/death/age rate of the society. Sure there are the occasional new products that see rocketed growth because it has not reach saturation levels, but they are not enough to dent the net growth of the national economy. Last time we had that was the internet revolution of the late 1990s. In the US and other first world economies (Europe) hit their saturated growth rate a long time ago, so future growth is measured based on the replacement and birth/death/age rate. A 3-6% growth rate is what many economist would expect in a robust first world economy. One huge problem in the first world economies that has translated to today’s economic stagnation was the RATE we hit maximum saturation levels. The advent of credit/debit and the growth in debt formation to reach accelerated consumption levels means that a first world nation will see growth rates rocket and then contract quickly at the expense of massive debt. When growth begins to contract and if debt service was based on the ability to use capital formation FROM accelerated growth, you can face a serious credit crunch and that translates quickly into a recession and/or depression. If debt formation was gradual and debt service was formulated on income, rather than capital growth, while the economy will not grow as fast and not reach maximum saturation levels as quickly – the debt service will be far more easily maintained and risk will be limited. In simple terms, the house flipper is betting on flipping the house to make a profit and carrying huge debt to do so. He has no income to carry the debt service for long periods and thus betting on flipping. That is what took down the housing market and it is also what is happening in first world economies, betting on growth, rather than income. When the Western economies collapsed in 2009-2010, there was hope. The rise of China and other 2nd/3rd world nations were still in accelerated growth. Many industries/products/services had not even come close to full market saturation in these nations. McDonald’s for instance was building over 400 new stores a year in China. Smart Phone sales were measured in 100s of millions. Car sales ramped. Movie sales. Buildings would go up. It was one of the fastest economic growth accelerations the world had ever seen. Debt formation rocketed and US companies found a new source of growth to off-set Western stagnation. While McDonald’s continue to see same-store sales in the US and Europe contract or stagnant and store formation was flat and in some cases contracting, it relied solely on China and 3rd world growth to carry the company. The S&P 500 became more and more reliant on third world growth as a measure of top-line revenue than domestic and first world. However, you can only build 400 McDonald’s every year for so many years until you have saturated the nation with McDonald’s. A billion mouths are a lot, but at some point you hit maximum saturation and growth rates begin to contract. Courtesy of wikipedia Meanwhile in the US and Western economies, the central banks were keeping domestic stagnant economies alive with massive easy monetary policies, low rates, cheap money, and taking on public debt to free up more access to credit in the private sector. Growth rate in the western economies were masked by the growth in China (and other 3rd world nations) as well as the Central Banks monetizing deficits and maximizes MORE debt formation. The West never really deleveraged, they just moved debt from one balance sheet (private sector) to another (public sector) – under the guise of the great economic ongoing Keynesian experiment. Since economies seem to be growing, if measured by GDP (reliant on trade with China) and devalued currencies, no one questioned the uber dovish monetary policies. Today’s problem is that China’s turbo-charged growth on debt formation has slowed significantly. China is still growing, but the measure of growth rate is shifting from new product markets to saturated markets that rely on replacement and birth/death/age rates. China is becoming a first world nation when measured on consumption and the West can no longer rely on China to lift all boats. Long Slow Growth Period We are entering a phase in which the western economies, reliant on trade, will see very slow and low growth rates. There is not another China to step in and carry the water, I am sure there will be - but not in the next few years. In previous market previews, I have wrote about Africa and India. Additionally Malaysia and others have the potential as well. Unfortunately there are too many obstacles in the short-term for them to rise up and carry the first world nations to prosperity. Looking Inward These are very dangerous times, because when economies slow, nations begin to look to blame others and take drastic action to protect themselves. We can see blame fuel hatred and protectionism. We are seeing that with rhetoric from Trump and the BREXIT. Sure there are some valid concerns they bring to the table and some of the ideas are worth considering, but if not taken in measure and with consideration, they can quickly become antagonistic policies. Socialism is also on the rise, much like the world in the 1930s. When Europe and the US suffered their recessions and depressions, people turned to government to solve problems. Money supply expanded, debt formation expanded, inflation exploded. Government became more ingrained in job creation and taxes, fees, fines, rose. Class warfare erupted and nations trade agreements quickly turned to trade wars. Many have not studied why Japan attacked the US in 1941. It wasn’t because they hated the US, it wasn’t religion, it wasn’t racism, it wasn’t for land – it was far more simple and what would have seemed far more benign in the beginning – it was over TRADE and access to resources. The US forced an embargo on Japan, cut Japan off from supplies, even took a military presence in the South China Sea blocking Japanese trade. I am not going to justify US foreign policy with Japan, but suffice to say cutting off an island nation of oil, food, and supplies – regardless of reason – creates only two outcomes, WAR or FULL SUBMISSION. Japan elected WAR. A war that was started over extreme protectionist trade policies. The Treaty of Versailles is also blamed for the rise of NAZI Germany. The radical socialist party that became fascist that suffered the world some of the greatest atrocities. Again, Germany suffering from economic woes, a suffocating treaty, one-side trade agreements, and much like Japan, they had two options: Full Submission or War. We know the route that Germany took. The laws of Supply & Demand drive trade. There is a reason that Sun Tzu’s Art of War is still taught in business and military schools around the world. 2,500 years old the text maybe, but the laws of Supply & Demand – that drive everything have not change. Sun Tzu stated that logistical strategies are even more important than the balance of power and the possibility of victory, because logistical success determines these points. Courtesy of wikipedia Luckily Hitler was a logistical fool, what ended the Third Reich was his two largest logistical mistakes – invading the Soviet Union and the supply chain needed in the harsh winters in route to Moscow and secondly, cutting off Rommel’s forces from taking the Suez and the oil fields to redirect forces to the West. Things would have turned out far differently if Hitler remained allies with the Soviets and supplied Rommel’s North African Corp to take Suez and the Middle East. Perhaps Sun Tzu’s text wasn’t translated to German? The belabored point is that the laws of Supply and Demand drive everything, from trade to the financial markets. When governments intervene, even with the best of intentions – via “FAIR TRADE” and protectionism, combined with central planning and Socialism – you can quickly end-up in some rather precarious relations with your neighbor, in which outcomes may not be favorable. WWII is an extreme, but our history is loaded with examples. Rome too did not fall from famine, war, or disease – it fell from a debt ridden economy and expanding deficit run social systems. Bread and Circuses never work in the long run, and only created entitlement as it tries to placate the people.

Support & Resistance

INDU 17,400 It was once support and we could see a solid bounce and an attempt to break out. However, I think we are now in a more cautionary investor mentality. We may see this level where resistance kicks back in. NDX 4,300 To be less accurate is a similar situation. We could see selling pressure in the 4260-4300 range. Again, look for an attempt to close above 4300 and put back in support. SPX 2040 Was, like the Dow Jones, the previous support and now has become potential resistance as the market struggles to regain a footing. The VIX has come off some and we could break below 20 today if the market holds the pre-market future gains. RUT 1100 The broader measure of market flow looked horrible. It broke 1140, then 1120 and then 1100. Clearly the buyers stepped away. To hold in at 1100 is important to convince me that the sell-off was only margin selling and not an ongoing exodus out of the equity markets.
Conclusion We remain in a potentially volatile market; elections, Puerto Rico, BREXIT, Fed monetary policy. The two day rout should be proof enough how quickly this market can turn and how truly fragile it can be. Liquidity shifts can change in a moment’s notice. We also must be able to separate out the facts from the fiction. Most of the rhetoric was built on assumptions of no merit. Mere subjective speculation driven by fear from Statism beliefs. The real impact of BREXIT – so far – has only been the radical move in currencies. Even after a formal departure, when the dust settles, immigration and trade will still be much as it is today. A few EU subsidies may hinder something here or there – but subsidies do not equate to real economic growth, but rather more debt. The Fed will not raise rates and it is far more likely that more easing will come, which could fuel markets higher. US is also seen as a safe haven, as is the dollar (for now) and that could drive equity markets higher. However, it is not a time to get long because you believe in a robust economy – you are long because it is the best option and you understand that equity growth is driven by monetary policies and is inflated by margin debt. I expect more volatility, not less.

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