The Storm Is on Its Way – Here’s How You and Your Portfolio Can Weather It

The LAMPP (Liquidity And Monetary Policy Profits) indicator is little changed this week. It’s barely on yellow, perched precariously on the razor’s edge of turning red.

But there is more than one storm headed our way that will knock our LAMPP into a bright, flashing crimson.

Not only do we have an excellent idea of how the Federal Reserve and the Treasury plan to impact the economy, but the hurricanes that are tearing through the country will have tremendous repercussions as well.

In fact, they could change everything.

Here’s what you need to know to protect your portfolio from the coming storms…

We’re About to Run out of Gas

The LAMPP has two components.

One is the money that the Fed pumps into the pool of cash that fuels stock market rallies. The other is the amount of new Treasury supply coming into the market each week. When the Treasury issues new bonds, it pulls cash out of the financial markets. It competes with stocks for the available cash.

It’s easiest to understand if you look at it like a gas station. The Fed fills the tank. The Treasury pumps gas out of the tank into its own tanks. It then uses that fuel to keep the US economy running on all cylinders. Without that money, the economy would only run on three or four cylinders instead of six.

Now, Primary Dealers (the institutional investors and big hedge funds) also fill up at those gas stations. When the Treasury drains the tanks, there’s less fuel left for the dealers and big traders. They can’t buy as much stock. In addition, it costs them more to fill up their tanks because there’s less fuel available to them. And the price of fuel rises.

If it’s not clear by now, that fuel is cash. Its price is the cost of money – the interest rate.

Here’s the problem…

The Treasury will start selling hundreds of billions in new Treasury bills, notes, and bonds as soon as Congress lifts the debt ceiling. It will drain most of the fuel from the station. There won’t be as much left for dealers and hedge funds to buy stocks, and stock prices will begin to fall.

You can think of the LAMPP as the fuel gauge. Right now, it’s telling us that there’s barely enough fuel now to keep the stock market engine running.

LAMPP-Indicator

When the Treasury starts sucking out more of that fuel, there won’t be enough to go around.

But the markets themselves are a source of fuel, and those dealers and speculators will turn to them to sell assets there to raise the cash they need to meet their obligations. Asset prices will fall.

Unfortunately, the Fed has put itself in a position that will only exacerbate the situation. It has promised to start siphoning cash from the market’s tank very soon, with its plan to “normalize” its balance sheet.

Sources in close contact with the Fed have told us to expect that announcement in September, and the Fed usually begins to implement new policy in the first month after the FOMC announces it.

That means October – and the timing could not be worse.

Both the Fed and the Treasury will engage in actions in October that will take cash out of the tank that fuels rising stock prices. It will turn the LAMPP decisively red.

Let’s break this recipe for disaster down…

Congress is almost certain to raise the debt limit around the end of September.

The Treasury will need to suck a massive amount of cash from the market’s gas tank in October.

And the Fed could compound the problem by starting up its siphoning pump in October as well.

We know that the Fed is due to start siphoning slowly at first, but will inevitably turn into a Dyson vacuum over the course of a year. Once the LAMPP turns red, it will stay red.

Treasury supply will be a big negative for a long time to come, pulling hundreds of billions from the market’s tank in the years ahead.

And worse, it could remain an even bigger negative than anyone suspected a couple of weeks ago.

Harvey and Irma are the reason.

Florida Isn’t the Only Thing in the Path of This Storm

Hurricane Harvey’s costs are now estimated at $180 billion of mostly uninsured losses.

We all know that early storm damage estimates tend to be low. What we don’t know is how much of Houston and East Texas can be rebuilt, and how much Federal money will come to rebuild it.

The amount will certainly be significant, which means a big increase in the deficit is coming. Lots more Treasury debt will need to be sold, and that will suction more money out of the financial markets.

Now here comes Irma. Let’s all pray that its current forecast track as of Sunday night is wrong.

As a longtime resident of South Florida, I’ve become somewhat of an amateur hurricane watcher… And this is the scariest one I’ve seen in 30 years.

The majority of the models used by the National Hurricane Center forecast that the most powerful and dangerous part of the storm – the northeast quadrant – will pass directly over Miami, Fort Lauderdale, and West Palm Beach. In case you aren’t familiar with recent census estimates, that’ns a region with over 5 million people and trillions in property value.

If you’ve been to South Florida, you know that many of the most expensive homes and high rise residential buildings line the coast. And inland lie vast swaths of cheaply constructed housing, mostly built since the 1970s.

This has long been an accident waiting to happen. And it’s happened before. Andrew, in 1992, ran east to west and, luckily, its area of damage was small. Frances, Jean, and Wilma came ashore as Category 3 hurricanes in the middle of the last decade. Their damage was contained as they weakened rapidly.

But a 1928 hurricane came ashore as a Category 5 and ran in a more northerly direction. It killed 2,500 people around sparsely populated Lake Okeechobee as the lake overflowed. Virtually all of the housing in West Palm Beach was destroyed.

South Florida hurricanes are not rare. The ones that run longitudinally up the coast are rare, but they have happened and they have been devastating. Irma has the potential to do that.

Hurricane-Path

The long-term forecast tracks go right over the tip of South Florida and up the center of the state. A storm of that strength hitting South Florida and going over the Everglades (which would enable it to maintain its full power for up to a hundred miles inland) could essentially destroy all on its east side and make the region from Miami to West Palm Beach virtually uninhabitable.

Once again, that’s 5 million people and trillions of property value that will be displaced.

The losses would be apocalyptic, resulting in potentially hundreds of billions in Federal expenditures to help rebuild. This would pour even more new debt supply on to the market, sucking cash out of the system during a time when the Fed says that it too will be draining the tank.

If this worst-case scenario does come to pass, we have to wonder if the Fed will stick to its guns. Two episodes of random acts of nature destroying hundreds of billions of dollars’ worth of US assets within the space of a couple of weeks would give the Fed the perfect excuse to restart the QE pumps to fund these massive reconstruction projects.

It could upend our expectation of a long-lasting bear market.

How to Batten Down Your Portfolio’s Hatches

The odds of the Fed reversing course would have been infinitesimal in the absence of these two storms. Now it’s a real possibility.

But it should not deter us from following our plan. If the Fed does reverse, it will not turn on a dime, and there will be time to get back in.

The Fed will send signals that a policy change could be coming. It may be short notice, but we’ll be able to react appropriately by following their public comments closely. We would be able to estimate the impact of that change to the LAMMP. Furthermore, the market doesn’t move until the Fed cash actually starts flowing. We¬† have plenty of time to adjust our strategy.

In the meantime, we should stick to our plan of systematically raising cash that I began to recommend to you a month ago. We should do so even more aggressively into the rally that we expect this month. That rally could get even stronger if the Treasury is forced to stop borrowing before the debt limit is raised.

Use that rally to lighten up aggressively… The LAMPP will turn red when the Treasury starts borrowing again.

Stay the course and stick with our plan of regular liquidation. Build up your cash as a matter prudence, and prepare to take advantage of the next buying opportunity. The LAMPP will tell us when it’s safe to start buying again.

Sincerely,

Lee Adler

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