Protectionism, Tariffs & Trading a Trade War

June 28, 2018 02:00 PM
Trade Wars & Volatility

MODERN TRADER explores the effect of a potential trade war on U.S. equity markets. Will it end the bull run or will low interest rates allow  U.S. equities to maintain its momentum? Read on. We also attempt to identify the key drivers of active equity hedge funds. 

While many analysts believe trade wars are bad for markets, sometimes markets can give clues to the environment that breeds trade wars. What are today’s markets telling us?  

“History doesn’t repeat itself but it often rhymes.” 

That famous quote, often attributed to Mark Twain, is commonly used to explain humanity’s inability to learn from our mistakes. Whether you believe that history repeats itself, rhymes or that we are capable of learning from it, the current trade war dust-up has some historical precedence. 

Under President Calvin Coolidge, Treasury Secretary Andrew Mellon repeatedly slashed taxes for the wealthy. The largest tax cut was passed in 1926. The top tax rate for the wealthiest was slashed from 46% to 25%. The middle class got next to nothing. The entirely predictable result was a massive tax cut funded speculative bubble in the stock market. That bubble famously burst on Oct. 31, 1929.

Realizing that they had better give something to the middle class, especially after the bursting of the stock market bubble, The Smoot Hawley Tariff Act passed the Senate on March 24, 1930 and was signed into law by President Herbert Hoover on June 17, 1930. This bill was passed despite the vigorous protests of virtually every well-known economist. And it was passed to “create American jobs.”

 It did create American jobs for about three months. Then Smoot-Hawley’s impact as a tax hike began to be felt. And then the bottom fell out of world trade as other countries retaliated with their own tariffs. This act helped grease the slide from an American recession to a powerful global depression. Long live the law of adverse consequences from short-term thinking.

So how the heck did the United States move so quickly from the roaring 20s to protectionism? The key was the massive stock market bubble. The equity bubble was an expression of the epic wave of euphoria unleashed by the unprecedented tax cuts. Extremes of euphoria are simply not sustainable. Like a sugar buzz, big tax cuts create an unsustainable spike in wild-eyed optimism. The ebbing euphoria was quickly replaced by rising fears. This transition from roaring euphoria to rising fear was a reversal in the collective consciousness, and the stock market accurately revealed that reversal. It is a historical fact that speculative bubbles never slowly deflate. Bubbles always burst. It is a law of collective human behavior.

Something like Smoot Hawley would be impossible in a healthy and sustainable bull market. Tariffs and protectionism are expressions of rising fear and pessimism in the collective mood of the nation. A bull market is the expression of rising hopes in the collective mood. This mood reversal from hope to fear was a reversal from “Yes we can” to “We cannot unless we get protection.” The transition from a stock market bubble to tariffs and trade wars allows us to closely track the cyclical reversal in the mood of the collective consciousness, and perhaps now more than ever.

Several markets are showing signs of being overheated, these potential bubbles are driving protectionist tendencies, and their ultimate bust will be proof of this and not simply a reaction to it. 

Bubbles & What They Mean 

Speculative bubbles never slowly deflate, and the bigger the bubble, the bigger the ensuing bust. A comparison to conditions that led to the dot-com bubble’s sudden end in March 2000 should give investors a lot to consider as the warning signs of another bubble continue to multiply. From its 5,132 peak of March 10, 2000 to its 7,637 peak of March 13, 2018, the Nasdaq Composite Stock Index is up 49%. The S&P 500 Index is up 85% from its March 2000 peak at 1,552.87 to the 2,872.87 high on Jan. 26, 2018. (see “Current credit bubble,” above).

Beyond the extraordinary heights of the major indexes, there’s another signal of record high bullish euphoria out there, and it should be a real concern. Margin debt has grown 140% from the dot-com boom peak of $125 billion to the recent $300 billion level. This is a signal of severe downside risk. Margin calls are why bubbles always burst and never slowly deflate. Once equity prices retreat enough to trigger margin calls, the risk becomes a cascade of long liquidation.

Why the bearish view? Because pricing patterns repeat themselves, and as a technical analyst it’s hard to avoid seeing the parallels. The S&P 500 is more richly priced than at any point in history, including 1929 — except for the final leg up of the dot-com bubble. Arguably, no one wants to ever again see such monstrous valuations as those in the peaking of the dot-com bubble, though there will doubtless be those bulls claiming that “this time will be different.”

We’ll have to wade into some technical analysis terms here to make our case, as demonstrated on the chart of the Shiller P/E ratio (see “Technical evidence,” below). We use Fibonacci Retracements — a set of ratios that help predict where market trend reversals tend to land — and apply them to the commonly used S&P 500 valuation measure, the Shiller P/E ratio, a cyclically adjusted number derived from the price divided by the 10-year moving average, adjusted for inflation. What we see is that Shiller P/E ratio just peaked and retreated from the 61.8% Fibonacci retracement of the December 1999 to March 2009 drop. The risk is that the Schiller P/E just completed a bear market correction of the losses from the 1999 peak. Based on the Elliott Wave patterns, the risk investors face is an eventual retest of the 2009 lows.

Again, we’ll have to get visual to explain why there’s heightened bubble risk now, this time looking at the Dow Jones Industrial Average. There are very few technical tools for dealing with the excesses of world-class speculative bubbles, but the Elliott Wave channel is one of those tools. The Elliott Wave channel (see “Waving furiously,” page 32) is a support line drawn through the lows of waves 2 and 4, and then a parallel resistance line drawn through the high of wave 3. The final wave 5 peak should overshoot the resistance line, and then keel over into a downtrend. The Dow Jones Industrial Average looks very much like a textbook example of an Elliott Wave channel peak of the entire advance from the 2009 lows.

Energy Bubble?

Crude oil and the huge amount of money in long crude positions is a complementary worry here (see “Specs ahead of the market,” above). There is no precedent for the extent of the bullish euphoria in crude oil. There’s an almost religious faith among oil bulls in the durability of the OPEC-Russia alliance, which has limited production and kept prices rising. There’s a curious lack of concern among the bulls that prices could get high enough to unleash a new tsunami of non-OPEC crude oil output — a distinct possibility now that U.S. sanctions on Iran could cut its production. And if the stock market is in a bubble that is very bad news for crude oil bulls. Every time an equity bubble has burst crude oil prices have been slammed (see “Follow the leader,” below).

Consider also that in the old days, before the North Sea, Alaskan North Slope and deep-water Gulf of Mexico fields went on line, there was a multi-year time lag between an OPEC-driven rise in crude oil prices and the ensuing surge of new non-OPEC output (see “Vicious cycle,” left, below). The OPEC dilemma is the nature of the markets: OPEC cannot sustain both high prices and market share. First, OPEC cuts output to raise prices, prices then rise; and then new non-OPEC output increases to fill the void caused by the OPEC cuts, prompting OPEC producers to fight to regain market share by boosting production, which leads to a supply glut and falling prices. And when OPEC cuts output again the cycle repeats, but this cycle happens faster now.

Prolific fracking programs have resulted in several thousand drilled but uncompleted wells in the lower 48 states – about 7,700, according to recent estimates from the U.S. Energy Information Administration. With a high enough price this underground storage will start to flow into the markets. And then there’s Saudi Arabia, one of the world’s three largest oil producers and always a major force in the market. Its state-run oil company, Saudi Aramco, is planning an initial public offering – the date is a bit of a moving target – but as the most profitable company in the world, there’s a strong Saudi desire to keep oil prices high to get to the top end of its valuation range, pegged anywhere from $2 trillion to $10 trillion. The risk here is that the Saudi desire for high oil prices to ensure a big, fat Aramco IPO payout will unleash yet another tsunami of new non-OPEC output.

The other factor working against oil prices staying high is seasonality. The pre-season crude oil rally is a winter to spring event, followed by a spring to summer drop. When last summer’s shallow seasonal dip could not even correct 50% of the prior advance, my 2018 spring target became $71.24 (which was slightly breached in mid-May). These spring peaks almost always occur on Mid-East fears. A Mid-East fear event is almost as reliable a spring seasonal signal as the first robin.

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About the Author

Walter Zimmermann is the Chief Technical Analyst at ICAP-TA. He has been a cycle-based technical analyst from more than 30 years focusing on major markets and the petroleum complex.