Here’s Why This Week’s Historic Drop Is The Start of A Recession

This Week’s LAMPP

 


The short term LAMPP is technically in green territory, while the long-term remains on the brink of a red signal.To learn all about how the LAMPP works, and how we use it to make money, start here.

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This past weekend was bookended by two gargantuan selloffs: a 666-point drop in the Dow on Friday (spooky!), followed by 1,175 on Monday, the biggest one-day drop in the index’s history.

I won’t say “I told you so,” but if you took my advice and converted 60-70% of your assets to cash by the end of January, you should be breathing a sigh of relief right now.

As the week grinds on, we’re seeing a bit of recovery, but I should warn you – don’t be too sanguine.

Officially it takes 2 quarters in a row of falling GDP for the NBER to call a recession. By the time that second GDP report comes out a recession will have already been under way for 7-9 months. The Fed probably will not reverse its quantitative tightening program, which actually sucks money out of the financial market ecosystem, until at least then. With no economic slowdown even in sight, it is virtually certain that tightening money will be with us at least throughout virtually all of 2018.

That’s plenty of time for tight monetary policy, which the Fed euphemistically calls “normalization,” to cause considerable damage to stock prices. Apparently that damage has begun this month. The chances are that things will only get worse. Here’s why.

Tax Data Shows Us How Much Money The Fed Will Pull Out of the System

The Fed calls its policy of shrinking its balance sheet “normalization.” But it’s really “Quantitative Tightening” or QT. QT is the exact opposite of QE, which added funds to the financial markets. QT actually withdraws cash from the system. We have expected that to cause financial asset prices, particularly stock prices, to fall. As the Fed ratchets up the size of the drains from the system, the impacts will grow. We saw the first effects over the past week.

The Fed announced in November that the “normalization” program is on “autopilot,” and that it would no longer report the changes in the FOMC statements. In view of that position, I think that they will be reluctant to take any action to reverse balance sheet “normalization” until there is, in their words “a material adverse event.”

I take that to mean at least a 20% plunge in stock prices, which the media and Street pundits seem to think defines a bear market. And their first action will be to reduce interest rates, not restart QE. That will only come much later.

There was no indication of recession on the horizon in the January tax data. The signs we saw in December that US economy appeared to be overheating have yet to be reversed. This probably ensures that the Fed will remain on a tightening course for the foreseeable future, despite the early February stock market plunge.

As far as gauging the strength of the economy, things are getting complicated with the tax cut that went into effect in January. One thing seems certain however. Federal revenues will decline substantially this year and that will be a huge negative for the market, especially with the Fed pulling money out of the system. Here’s what you need to know to protect yourself from what’s to come.

Year to year comparisons will be questionable until January 2019 because it will be difficult to accurately adjust for the impact of the tax cuts. But the data will show us how much the tax cut will cost the US Treasury. That’s money that it will need to raise in the market by selling debt.

Tax collections rose year to year in January, despite the tax cut taking effect. The calendar was responsible for the bulk of the increase in withholding, with an extra filing day this year vs. January 2017. The daily data shows that collections were strong early in the month as employers needed time to adjust withholding rates. Collections then collapsed in the latter half of the month. Withholding taxes rose 8.9% year to year in January, but they fell sharply at the end of the month as employers implemented the new withholding tax tables.

Excise taxes were also up. The calendar plays less of a role here because these taxes are collected at mid month and month end on a 2 week lagged basis. They were up 4.3% representing the mid-December to mid January collections. They are collected on unit volume not sales revenue, so they do not contain an inflation component. At 4.3% growth, it means that the US economy continues to run hot.  This will encourage the Fed to continue pulling cash out of the system.

As the Fed continues to tighten the screws through October, increasing the amount of its systemic withdrawals from the current $20 billion a month to $50 billion, the recently passed Federal Tax cuts will only exacerbate the problem.

The earliest indication from the current tax data is that the Congressional Joint Committee on Taxation estimate of a revenue loss of $270 billion will be close to the mark. The Treasury will need to raise $20-25 billion a month to cover that sinkhole in the budget. That means that the Treasury will need to sell that much additional new debt, in addition to needing to sell tens of billions in additional debt each month to redeem the Fed’s holdings.

Somebody needs to buy that debt. That somebody used to be the Fed. Under QE, the Fed printed enough money to fund every single dollar of new Treasury debt. But the Fed is no longer funding new Treasury debt. In fact, it is exacerbating the situation with its “normalization”  program. With the Treasury selling $20-25 billion in additional debt and the Fed now pulling out another $20 billion, investors and dealers will need to come up with $40-45 billion this month and in March to buy the new debt issuance. Those amounts will increase quarterly to $70-75 billion in October.

In view of that, as bad as the past week was, we could see many more like it this year.

The LAMPP Warns Us to Continue Raising Cash


The Long Term LAMPP remains green, just barely. It has fallen to its lowest level since 2010, but it did not cross the signal line. It is perilously close to crossing that line, which is its 78 week moving average. A drop below that line would trigger a red signal.

When the debt ceiling is finally lifted and the Treasury returns to the market at full speed, the LAMPP will turn red, if it hasn’t already by then. It is so close to the line that it could come at any time. But it should definitely occur once the debt ceiling is lifted and any restrictions on new Treasury issuance are eliminated.

In January, Fed draining operations increased to a total of $20 billion per month, from $10 billion. That will rise quarterly to $50 billion per month in October.  This drains cash from the banking system. Meanwhile the tax cuts have begun to cut into Federal Revenues. The Treasury will need to issue more debt. That additional supply will also push the long term LAMPP lower.

The Short Term LAMPP edged back up into positive territory in mid December. Each time the short term LAMPP line has moved up from red territory to even minimally above the 100% line, the market has rallied. It did again this time but it didn’t stick. The short term market is on a hair trigger. With the short term LAMPP also barely above its signal line, the situation is extremely tenuous. As I pointed out last week, the margin is too close for comfort.

Even though the Short Term LAMPP is still technically green I have been warning that this was not a signal to be buying long term positions. The Long Term LAMPP has been, and remains, too close to turning red to be doing that.

Consequently, I am sticking to my recommendation to raise cash. The original plan from September was to sell small amounts systematically to get to 60-70% cash (more or less depending on your personal situation) by the end of January. If you started late, I recommended reaching that goal by the end of March.

I see no reason to change now. If anything, the selloff of the past week increases my conviction. I consider it at least a warning shot across the bow.

Sincerely,


Lee Adler

4 Responses to “Here’s Why This Week’s Historic Drop Is The Start of A Recession”

  1. Michael Marcinkiewicz

    First I would like to correct a part of your article. A recession is NOT 2 qtrs in a row of declining growth. Your statement implies that if in qtr 1 GDP is 2.6 % and in qtr 2 its 2.0% it would mean we are in an official recession. This is NOT correct. A recession is 2 qtrs in a row of NEGATIVE growth. e.g qtr 1 GDP is -1.0% qtr 2 GDP is -.5%. That would be a recession

  2. Lee: A few questions please. Jim Richards is talking about the IMP instituting The SDR “basket” of currencies to be used as a means of settling international trade transactions. That doesn’t bode well for the dollar or US bond rates with demand dampened. Have you heard anything about that scenario? If so what affect do you see on the markets?

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