Will 2018 Scare the Markets?

Happy New Year!

I’m starting the year off right with my six predictions for 2018. Surprise! They’re bearish. They’re my dirty half dozen, and you should think of them as risks.

If one or two of them come true, it’s probably a Nostradamus-like success. I don’t make predictions based on 100% certainty (and anyone claiming such certainty also likely has a bridge to sell you). Rather, I focus on subjects that are on my mind right now and project how they could play out in 2018.

Now, to the list!

Bitcoin Prices Will Fluctuate Between $2,000 and $60,000

Bitcoin was all the rage in 2017, especially amid its parabolic rise in the fourth quarter. It’s reached a phase of public fascination that usually indicates unrelenting price increases aren’t sustainable.

Many talking heads in the financial media have said that the introduction of Bitcoin futures legitimizes the cryptocurrency as an asset class. To that, I say phooey! (I’m trying to swear less in 2018…)

First, Wall Street will create any product that it thinks it can make money on. They’d create futures on Green Bay Packers games if there was a market for it.

Second, Bitcoin futures started out with a thud. The notional value of the contracts is miniscule relative to the market valuation of all the Bitcoin in circulation.

Third, Bitcoin futures are settled in U.S. dollars. That’s ironic, considering Bitcoin is a “currency.” If bitcoin futures were settled in Bitcoin, we could have a truly wild market!

In my mind, Bitcoin is nothing more than a vehicle for speculation. It’s not money. Just because two pizzas were bought with Bitcoin doesn’t make it a medium of exchange. Furthermore, people seem to be confusing blockchain technology (which has interesting prospects) with Bitcoin.

If the speculative fervor continues to stay white hot, I expect Bitcoin can rally much higher. If governments step in, there’s a security breach, or competition increases, the pullbacks in price will be death defying.

Volatility Will Increase Dramatically in 2018

The markets have been in a period of unprecedented low volatility. The record number of trading days without a 3% downdraft will come to an end in 2018.

But it’ll likely get much worse. Disappointing economic growth, higher interest rates, the threat of war, and increased nationalism threaten the confidence of the markets.

When the levee breaks, and the next bear market occurs, it will be worse than the last two bear markets. When the Internet Bubble popped, it was mostly technology stocks that took a beating.

Several years later, in the collapse of the housing crisis, stocks across the board got hit hard, but many rebounded well before the indexes hit their lows.

This time, everything is priced dearly.

The median price-to-sales ratio on the S&P 500 is so far outside the normal bounds that it’s unlike anything in history. These metrics scream “revert, revert!” And this mean reversion will be very painful. Unfortunately, there’ll be almost nowhere to hide to avoid that pain.

War with North Korea Is a Higher Probability Than What’s Priced by the Market

Kim Jong-un struck a conciliatory tone to start the year and seemed to offer an olive branch to the South Koreans to start dialogue. Maybe that’s in the spirit of the upcoming Olympics. That glimmer of hope will be short-lived.

The fact of the matter is that North Korea’s nuclear ambitions have not changed, and the regime is nearly singularly focused on being a credible nuclear threat. There’s plenty that could go wrong in 2018, including a failed missile test like the one the North had last year where the missile exploded in one of its own cities.

Next time, it could be a failed test where the missile comes down in another country.

The rhetoric also remains high with recent barbs about who has a bigger nuclear button. This is the world we live in, folks.

Senator Lindsey Graham of South Carolina has pegged our odds of a war with North Korea at 30%. They should be much higher, in my opinion. If the U.S. is determined for the North to not possess a credible nuclear threat, then this verbal conflict has to come to a head some other way. Time is running out, so 2018 looks to be the most probable year for this to happen.

Not a Single Job Created from Tax Cuts

Very few companies pay the statutory tax rate. Big corporations staff up to the gills with tax accountants and lawyers to figure out how not to pay taxes. A significant portion of the earnings in the S&P 500 is generated overseas, and often those profits stay overseas.

So, the tax cuts are a lot more noise than truly beneficial to the economy. I do think they’ll be beneficial to earnings somewhat, just not as much as advertised.

We’ve seen this movie before, where companies get preferential breaks to bring cash back to the U.S. And, what do they do with it? They buy back their own stock, which will happen again this time, and the next time as well.

Companies use their cash hoard to buy back stock and financially engineer their results. Not hire people. It’s been going on constantly this century and there’s no reason it will change now.

Interest Rates Go up, and the Dollar Rallies

Interest rates will continue to rise, and I don’t just mean the Federal Reserve raising rates.

In my mind, the LIBOR rate is of ultra-importance. Investors with big accounts at major banks can typically pledge their stocks and bonds to tap into a line of credit and use those borrowings to fund their lifestyle. For years, when rates were near zero (and the market was going up), this was a great trade. However, buyer beware!

LIBOR rates in U.S. Dollars are breaking out to multi-year highs and are well higher than the Federal Funds Rate. That could be very bad news for the markets. Investors have used their lines of credit for non-investing purposes. If the market were to correct and they receive a margin call, they’ll be forced to sell even more stock because the line of credit they used is either spent or in something illiquid like a boat.

You can always buy a boat, but you can’t always sell one.

This combination of rising rates and spent capital will only add to the downside pain in the market.

The dollar has taken a bit of a drubbing recently. But, with higher interest rates and greater volatility, it’ll rally sharply at some point in 2018 as a safe have asset class.

Economic Growth Disappoints

The only way we get to a 4% growth rate – like the administration keeps suggesting is possible – is with the stroke of a pen. In other words, the government just fills in the blank and like magic determines that the economy grew 4%.

There’s no way that happens on a sustainable basis. Again, tax cuts might help a little, but if you compare the annualized growth rate in working-age population in the U.S. to the annualized growth rate of productivity between the U.S. and other major developed and emerging economies, the U.S. is in a lackluster position.

As a result, high hopes for 4% economic growth will be met with disappointment.

Uncertainty is the Only Certainty

Lest we forget, last year saw record high after record high in nearly every corner of the market. Conventional wisdoms were turned on their heads or disappeared completely. Between crytopcurrency manias, Twitter brinksmanship, and an even-more-insane political climate in Washington, it’s even harder to say what’s going to happen in 2018.

Good investing,

John Del Vecchio
Editor, Hidden Profits

This post was originally published on Economy & Markets and can be seen here.