Monday, December 19, 2016

Not a Long Lasting Trend

The market is now in a trending phase, with stocks and dollar uptrends, and a bond downtrend.  Based on what I have mentioned about the Trump tax cuts, and overvaluation and aging population, the fundamentals do not support this trend to continue for much longer.  Sure, the market can remain irrational for a long time, but you need the investing public to have something more concrete than Trump magic and hope to keep this rally going.  All the measures that Trump will take to boost the economy are short term, and are long term unsustainable because the budget deficit would balloon to a point where the stimulus becomes a net negative, keeping interest rates artificially high.

Soros has stated that the participants in the market are fallible, and oversimplify complex systems.  He also mentions that in his theory of reflexivity, two functions determine prices:  1) the perception of reality, and 2) the behavior based on that perception by market participants.  I agree with his definition of what moves markets, but his writings make his theories more complex than they really are.  He could have explained his theory concisely in a couple of pages, rather than over a half a book.

The current perception of a stronger US economy and higher inflation in the next few years due to Trumponomics is gaining popularity and the prices reinforce the perception, in a feedback loop that keeps the S&P and dollar going higher, and Treasuries lower.  But the perception will be tested in 2017 and 2018, because that is when the actual results have to start coming in.

The perception will be invalidated sooner than many people think, as it is based on oversimplistic and overoptimistic logic.  It overestimates the ability of fiscal spending and tax cuts to boost the economy when it is already running near full capacity.  Fiscal stimulus has always been less effective in boosting the stock market than monetary stimulus.  After all, the markets are based on supply and demand, and fiscal stimulus that is tax cut heavy is a mere reallocation of assets from the bond market to a mix of cash, stocks, bonds, and real estate.  By making bonds cheaper, they have taken money away from the bond holders' hands and given it to those who get the tax cuts.  Theoretically, there is no net addition to the supply of dollars like you would get with monetary stimulus.  Monetary stimulus is always the easiest way to boost the stock market, as we have seen since 2008.

If this strong US economy perception gets proven false, it will lead to a spectacular reversal in the stock, dollar, and bond trades.  Watch for that sometime in 2017.

I have always traded better around market turns than when the market is strongly trending.  It has not been easy to trade as a fader for the last few weeks.  But 2017 should provide much better opportunities for those trading based on fundamentals and not short term momentum.  Timing is the tricky part, but the tax cut bill being introduced and passed in Congress will probably be close to the climax of this up move.   That is likely to happen in the spring of 2017.  In the meantime, I will not be taking any long term positions either short stocks or long Treasuries.  But after the bill gets passed, it will be time to look to take a long term short (12-18 months) in S&P and long in Treasuries.

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