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I recently enjoyed a holiday party with my colleagues at Money Map Press, one highlight of which was a vigorous conversation with Shah Gilani about the impact of Trump's tax cuts on the markets. I have deep respect for Shah's analysis (and his excellent track record). He actually has an uncanny knack for finding bearish trades in a bullish climate, which the contrarian in me appreciates, and his writing is always incisive and entertaining.
However, on this issue, he is a confirmed bull, while I am a confirmed bear.
We enjoyed our argument immensely.
Then – after taking a bit of a break for some eggnog – I visited my comments section on Sure Money and lo and behold, a smart reader named Jesse had asked me the very same question…
Kismet! It was meant to be.
So without further ado, here's my response to Jesse (and to Shah), followed by several other incisive reader questions.
Jesse: Hi Lee. Enjoy your articles. Your views about tax cuts and the market still tanking seem to conflict with what Shah Gilani says. Can you expound on how a tax cut will be bearish? Here is a cut and paste:
What's going to happen next is that tax cuts will flood already flush corporations.
They'll enjoy a 10-year run of record low capital costs, record profit margins, and record profits (especially at giant tech companies) with even more ways to raise cheap capital, fatter profit margins, more profits, and more cash to plow back into their pockets.
By pockets, I mean their stock options packages, the price of their stocks, and the dividends they throw off. It will create more and more momentum, lifting markets higher and higher.
That's the "miracle."
Riding the market higher is the only way middle-class Americans are going to get their share. Now and moving forward, if you aren't in the market, you're losing money.
Thanks – Jesse
Lee: Hi Jesse. I have no doubt that Shah will quickly adjust his outlook when the market proves him wrong on this issue (INSERT BIG SMILEY HERE). But all kidding aside, when views are this far apart, it's obvious that one of us will be proven wrong, and we will need to make the adjustment in outlook as soon as it becomes apparent that our considered outlook isn't playing out as expected.
Of course, we might both be proven wrong and the market could trade in a range for a few years. In that case we would both be positioned to take advantage of both declines and rallies.
So here's how and why I think that a tax cut will be bearish.
There's no doubt in my mind that tax cuts will goose the economy for a time. But eventually the corporate CEO and CFO class will find ways to divert the extra cash into their own pockets, just as they did with QE. Ultimately, the long run beneficial effect to the economy is questionable, and more importantly, irrelevant. They are second order effects.
The first order effects are these….
Federal tax revenue will decline and the deficit will grow. The U.S. Treasury will be forced to sell more debt to cover the shortfall. That will put supply pressure on both the bond and stock markets.
Remember, at the same time the Fed will be pulling money out of the system. Instead of the Fed essentially buying or funding the purchase of Treasuries as it did under QE, it will now be reducing the amount of cash available to absorb the massive amount of new Treasury debt that will hit the market every month.
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By next October, the Fed will be draining $50 billion in cash from the market. That will force the buyers of new Treasury debt to liquidate something at the margin. It could be either other Treasury paper or stocks or both. This will only add to the supply pressure. As stock and bond prices fall, margin calls will follow. That will both destroy cash as it is used to retire the margin loans and also add to supply pressure.
So the tax cuts may well boost GDP a bit and might even prove a one-time boost to corporate profits. But any acceleration in the top-line economic numbers will only encourage the Fed to remain on a course of credit tightening.
And that brings us to Rule No. 1: "Don't fight the Fed." If the tax cuts have the intended effect of boosting the economy for a while, then that will be bearish because it will encourage the Fed to stay tight.
Markets top out when the news is good. So I think that this tax cut will prove to be a quintessential case of sell the news. Markets don't top out on a dime, however. We don't have to sell everything all at once. That's why I've been recommending selling small amounts of stock at regular intervals to reach 60% to 70% cash by the end of January or the end of Q1 at the latest. If by then the market hasn't signaled weakness, I'll have to consider whether to redeploy cash. If my analysis is correct, it won't come to that, and we'll be well positioned to protect against and take advantage of the decline I expect to come.
Stay tuned right here for any change in that outlook as we chronicle the changing liquidity and technical picture of the markets.
And now another intelligent reader who has questions about the tax cut (and other things)…
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About the Author
Financial Analyst, 50-year charting expert, finance + real estate pro, and market analyst; published and edited the Wall Street Examiner since 2000.