Your Quick Guide to the "Perfect Storm" That Could Cause a January Recession

Over the past few weeks, I've written a number of articles about why stock prices are due to take a nosedive soon.

I've had my eye on January for some time because a confluence of factors are all coming together in Q1 2018, creating a "perfect storm."

The Fed is not known for its powers of early recognition. The next recession, whenever it comes, will be well under way before the Fed gets a clue. Officially it takes two quarters in a row of falling GDP for the NBER to call an official recession. By the time that second GDP report comes out, a recession will have already been under way for seven to nine months. The Fed wouldn't loosen policy until at least then. With no economic slowdown even in sight, it is virtually certain that tightening money will be with us at least through most if not all of this year.

That's plenty of time for tight monetary policy, which the Fed euphemistically calls "normalization," to cause considerable damage to stock prices. It hasn't started yet, but a series of red flags in the first quarter suggests that time is coming.

Here's your quick and dirty guide - and what to do to prepare...

Five Red Flags That Point to a January Downturn

I've discussed most of these "red flag" factors at length in other articles, which I've linked for your convenience! They include:

The Trump tax cut will exacerbate the Treasury supply problem. The U.S Treasury will be sucking up the vast majority of investable cash. Some buyers of the Ts, most importantly, the primary dealers, will liquidate stocks to be able to absorb the new Treasury supply. That selling pressure will show up as falling prices. We've talked about all this at length elsewhere.

But for now I'd like to show you the connection between strong economic data - as expressed in taxes - and a recession on the horizon.

Tax Data Tells Us That the Fed Will Keep Tightening

Withholding and excise tax collections soared in December. November's weakness is now just a distant memory. The strength in tax collections means that the U.S. economy now appears to be overheating, ensuring that the Fed will remain on a tightening course for the foreseeable future.

The tax data gives us a leg up on the rest of the market, which only has its eye on the lagging economic data releases. The tax data has the advantage of being available to us in real time. The U.S. Treasury publishes it every day with just a one-day lag.

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Withholding taxes are particularly interesting because all businesses collect them from their employees' paychecks. The federal government requires that big businesses in particular deposit those collections in the U.S. Treasury very quickly. This is as close to real-time economic data as there is.

Due to the extreme volatility in the daily data, I use a double-smoothed moving average that approximates a monthly average. It increases the lag to a couple of weeks, but I also plot the daily data on a chart so that we can still see the current trend. It's like a stock chart with daily prices and a 20-day moving average. Both sets of data are visually useful.

The tax numbers below are telling us that economic data remains strong - and strong economic data will ensure that the Fed stays on a tightening track.

Withholding tax collections roared back in December after falling to the cusp of a recession signal in November. There's no recession on the horizon right now. That's not bullish. Strong economic growth will keep the Fed on course for shrinking the balance sheet.

While I would expect to see collections peaking near here, the trend of the daily data has yet to roll over. The economy was still cooking as December came to a close.

The annual growth rate in withholding rose to a manic +9.2% as of Dec. 29. Obviously, big year-end bonuses to upper-echelon earners played a huge role in that. We know that job gains and wage growth to the general population are nowhere near these levels.

This number is before inflation. Average weekly earnings have lately been growing at somewhat north of 2.5% (but there's no inflation, ahem). So applying a 2.5% wage inflation factor indicates that real growth is in the vicinity of 6.5%. I would take that with a grain of salt as an indicator for the broad economy given the skewing caused by those at the high end. Even so, the top-line economic numbers for December should be very strong. That will surprise the market.

Eventually, tighter money will begin to bite and stock prices will start falling. Multiple factors come together in January that I have covered in other reports, including the ECB cutting QE, the increase in U.S. government borrowing due to the tax cut, and the increased size of the Fed's draining operations. These factors mean that "eventually" could come as soon as this month. As always, we must rely on technical analysis for the specific timing. The trend is your friend until it isn't.

How to Play the Coming Recession - Whenever It Arrives

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Early in 2017, when the economic data was weak, many bearish pundits scoffed when the Fed said that the weakness was likely to prove transitory. It was transitory. That's one reason why the Fed has steadfastly moved toward the goal of starting balance sheet reductions last October.

The other reason is that the Fed really is worried about asset bubbles. Fedheads have discussed it. I believe this is their real motivation for the tightening program. Both of the last two tightening cycles grew out of the Fed's concern about major asset bubbles. Now it's going to have strong economic data to back that decision.

So the Fed is tightening and will continue to tighten, and we all know Rule No. 1, "don't fight the Fed." But right now, most big players are fighting the Fed, which reminds us of Rule No. 2, "the trend is your friend - don't fight the tape." No doubt we're playing with fire as we continue to trade from the long side.

That's where the vast preponderance of trades from my Wall Street Examiner Daily Trades List short-term technical trading algorithm have been throughout December and the first few days of January. Those trades have done very well. The few short-side recommendations that have come up have been merely treading water with an inconsequential net gain.

But I expect that to change in the weeks ahead. We should start to see more shorts and fewer longs. Over that time, I will continue to report prospective short-term trades, both longs and shorts, so that traders can take advantage of both the strongest stocks and the weakest. Soon I will begin sharing some of those picks with you right here and at Sure Money. So stay tuned!

The LAMPP Edged Even Closer to a Red Signal This Week

The long-term LAMPP remains green, but it edged closer to the signal line over the past week. Things are now touch and go. A red signal could come at any time.

When the debt ceiling is finally lifted and the Treasury returns to the market at full speed, the LAMPP will turn red within weeks, if it hasn't already by then.

This month Fed draining operations are increasing to a total of $20 billion per month, up from $10 billion. This will drain cash from the banking system. That will rise quarterly to $50 billion per month in October.

$97 billion in Treasuries on the Fed's balance sheet will mature in the first quarter. The Fed will tell the Treasury to repay $36 billion of that. That money will disappear from the banking system. It will reduce the amount of cash that feeds demand for securities.

The short-term LAMPP edged back into yellow territory in mid-December. Long-side trades in the Wall Street Examiner Pro Trader model trading portfolio have done very well in recent weeks. Short-side trading picks have been few.

In the meantime, I would not be buying long-term positions. In addition, any short-term trading from the long side should be watched closely for support breaks. Only when the long-term LAMPP turns red would I concentrate on trading from the short side. Prior to that, I would pick and choose shorts cautiously.

Liquidity is the key to generating profit on a monthly basis, and Lee Adler's Sure Money is here to help you find it. Twice each week, Lee updates his readers on the flow of liquidity in the markets and shares his best strategies for staying ahead of the tide. To get his research delivered directly to your own inbox, just click here. There's no charge.

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Financial Analyst, 50-year charting expert, finance + real estate pro, and market analyst; published and edited the Wall Street Examiner since 2000.

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