Is The Fox In The Hen House?

The Trump Administration's proposed tax reform plan was released this past Wednesday (with great fanfare).

In comments on Wednesday while in Indianapolis, specifically relating to his Administration's tax proposal, President Trump said: "Our framework includes our explicit commitment that tax reform will protect low-income and middle-income households, not the wealthy and well-connected," Trump promised. "They can call me all they want. It's not going to help. I'm doing the right thing, and it's not good for me. Believe me!"

Wow! Given the details of the tax "reform" proposal that was actually released to the public on Wednesday, we can only assume that there was some sort of "last minute switch"! If we are to give President Trump the benefit of the doubt, which we must, then this is the ONLY explanation possible given the following analysis of Mr. Trump's tax proposal as completed by the Tax Policy Center:

1. Taxpayers in the top 1% (incomes above $730,000) would receive approximately 50% of all proposed tax cuts, and their average after tax income would increase by 8.5%.

2. Taxpayers in the bottom 95% would see their average after tax incomes only rise between 0.5% and 1.2%.

Other proposed tax cuts in the Trump Administration's "Unified Framework" for tax reform include the following:

1. Elimination of the Inheritance Tax (Donald Trump's family could save as much as $4.0 billion on this proposed tax cut alone given his claim that he is worth $10.0 billion)

2. Reduction of the tax on "pass-through" business entities to a maximum of 25% as compared to the current maximum of 39.9% (Donald Trump and his family are known to have multiple "pass through" business entities)

3. The so-called "Alternative Minimum Tax" (AMT) is to be repealed completely in the Trump Administration's framework (according to the NY Times, the AMT is known to have cost Donald Trump $31 million in 2005, the only year that we an actual Tax Return for President Trump)

"It's NOT good for me! Believe me!"

According to the Tax Policy Center, the Trump Administration's tax reform proposal will reduce the Federal Government's net revenue by $2.4 trillion over the first 10 years and $3.2 trillion over the second decade. These numbers could be substantially worse if the proposed elimination of multiple tax deductions is NOT included with the actual tax cuts!

Stock investors cheered President Trump's tax plan last week! They believe him when he says that this will be the biggest tax cut ever for business and that he has the votes to pass this legislation in Congress. And maybe he does (but not likely)!

The Republican Party has the majority in both the Senate and the House of Representatives, but there are "factions" within the party that can be considered "deficit hawks". My view is that the Trump Administration's tax reform "framework" has no chance of passage in its current form!

So when does reality set in? Perhaps there is no time like the present! The sobering reality is that tax reform is complicated! And stock investors may very well wake up Monday morning and feel that it may be a good time to take some chips off the table!

Let's take a quick look at the Russell 2000 Index, which closed at a record high last week and jumped almost 2% on Wednesday alone (in response to the Trump Administration's Tax Reform framework)!

If you go to the iShares website (www.ishares.com/us/products/239710/ishares-russell-2000-etf, and search for the Russell 2000 ETF (symbol IWM) you will see the following information:

Cool Stuff! The P/E ratio looks very reasonable at just 20.87.

However, what I found most interesting was the information tag (i) on the P/E Ratio line. If you click it, here is what it says:

What? "Negative P/E ratios are excluded from this calculation" !!

So the P/E ratio for the Russell 2000 is NOT really 20.87! In fact, it's nowhere even close to that "reasonable" value. In the latest weekly edition of Barron's Magazine, the P/E ratio for the Russell 2000 Index is 97.96 as calculated by Birinyi Associates using the trailing 12-month earnings for each company. 

Wow! 

If we were just coming out of a recession, when corporate earnings were just starting to recover, maybe valuations of 97 P/E could be rationalized, but not after 8 1/2 years of recovery. When the next U.S. economic recession begins early next year, you can be sure this P/E number will get a lot worse! And if owners of this popular ETF ever want to liquidate, what kind of bids will they receive when scores of component stocks are in free fall because they just aren't worth anything (negative P/E ratios)!

Beside the overwhelming evidence that the U.S. Federal Reserve is now in "tightening mode", and beside the fact that the next Chairman of the Federal Reserve will probably be Kevin Warsh, a well known monetary hawk, here are just a few exogenous variables which could negatively impact U.S. and global stock markets immediately ahead:

1. The Iraqi Kurds have voted for independence. Will there be a military confrontation in this key oil-rich area of  northern Iraq?

2. Catalans will vote on an independence resolution tomorrow, Sunday, October 1st. This vote comes without sponsorship from Spain's central government in Madrid. The potential consequences of a YES vote here are significant to the future of Spain (and may disrupt financial markets).

3. The U.S. Justice Department's Special Council Robert Mueller has been fairly quiet despite the enormous political (and economic) ramifications of his investigation into Russian interference into our last Presidential election. How will the financial markets respond if Mr. Mueller reports that the Trump Administration colluded with the Russians in support of Donald Trump. And what if Mr. Mueller's investigation finds information "beyond a reasonable doubt" that individuals within the Trump Administration, and maybe even President Trump himself, obstructed justice (among other potential charges)?

4. It is being well reported today that North Korea is moving missiles out of its development area. Will the North Koreans launch these missiles? And more importantly, what will be the target of these launches? Last Monday, the North Koreans claimed that President Trump's recent comments represented a declaration of war against North Korea!

5. The U.S. has threatened trade sanctions against China and also threatened to renege on the Iran Nuclear Deal, but the more interesting trade squabble right now is with Canada. The United States has said it will impose tariffs of up to 200% on goods imported from Bombardier, a major Canadian aircraft and defense contractor. Canada is our second largest trading partner!

6. Among the most crowded derivative trades in the financial markets right now is the "short volatility" bets (which have been giant winners). If and when markets actually return to "normal" volatility levels (or worse), how will stock prices respond? Is it possible to see another "flash crash" like we saw on May 6th, 2010? The Dow Jones Industrial Average fell almost 10% in just minutes that day! And many big name stocks actually had NO BIDS! Could that happen again?

Here are some interesting statistics relating to volatility:

1. In the year ended September 30, 2016 there were 23 days when the S&P 500 fell 1% or more, 6 days when the SPX fell 2% or more, and 1 day when it fell 3% or more.

2. In the year just ended September 30, 2017, there were just 5 days when the S&P 500 fell by more than 1%, and there were NO days when it fell by more than 2%!

You can see why the "short volatility" trade has been so successful and continues to be so popular now! However, it appears to me that no one is really sure of the potential impact on the overall stock market if volatility suddenly upticks significantly in response to some unexpected event. In late 1987, implied volatility in the S&P 100 Index options (more popularly known as the OEX) surged to 250 as the stock market crashed on October 19th that year and naked out-of-the-money put options suddenly went deep into the money. The implied volatility of the S&P 500 Index options now (as measured by the VIX) is just 9.51 as of Friday's close, 9/29. Friday's close in the VIX was the lowest weekly close, lowest monthly close, and lowest quarterly close ever! And here is the latest CFTC weekly report on VIX Futures (courtesy www.zerohedge.com):

VIX Futures - Net Speculative Positioning
(per latest weekly CFTC report)

Official monthly chart sell signals have been triggered in my computer trading system at Friday's close (9/29) in the following stocks and ETFs:

ADBE, CCL EQIX, ICF, IEF, IYR, KO, NI, ORCL, PG, TLT, VALE and XLU

Bottom line: We haven't heard the phrase "liquidity squeeze" in a long time. However, all the pieces are in place now for a surprising liquidity squeeze that will soon take its toll on financial asset prices, with U.S. stocks leading the way down! "Cash" will soon be king again!!

Russell 2000 Index Monthly Chart with Computer-generated Buy & Sell Signals

Adobe (ADBE) Monthly Chart with Computer-generated Buy & Sell Signals