November 29, 2017

Stocks rose sharply yesterday as investors reacted to generally positive comments from incoming Fed Chair Jerome Powell and the passage of the tax reform bill by the Senate Finance Committee. Oh yes, and Bitcoin soared to over $10,000 per coin. No one seemed to care that President Trump and leading Democrats were fussing about a possible government shutdown in two weeks. I will discuss all four briefly.

To sum up Mr. Powell’s confirmation hearing, it appears he is on the same page as Janet Yellen. We should continue to expect slow gradual increases in short term rates, assuming the economy stays on the same glide path of 2-3% growth, with inflation gradually rising toward 2%. Should growth move outside the predicted range or inflation rise or fall faster than expected, then the Fed will adjust accordingly. While Wall Street liked what it heard, frankly I don’t see that it should have expected Mr. Powell to say anything different. If there has been any Fed chatter lately, and not just comments coming directly from Mr. Powell, it is that inflation looks likely to stay low for longer and that ultimately, the reduction of the Fed’s balance sheet may not be much more than $1 trillion spaced out over many months. If, indeed, there was a sigh of relief rally, it’s fair to say that it is now over, and until the economic or inflationary glide paths change, the Fed will not be the lead story going forward.

As for tax reform, while it wasn’t a certainty that the tax bill would clear the Senate Finance Committee, such an event was highly likely. So far, no Republican has come out and declared that they would vote No on the bill. Several, however, have voiced reservations. A couple do not like the fact that big corporations will see a cut in rates to 20%, while small businesses whose owners pass income through to their personal tax returns will pay upwards of 35%. There will almost certainly be a fix to close that gap a bit, although how it will be paid for remains a question. A couple of other Senators, led by Bob Corker, worry that if the tax bill doesn’t help to generate accelerated growth, deficits will rise more than expected. They want a provision inserted that will automatically increase taxes in some manner to keep deficits from exploding. Once again, they will probably earn some changes, but the devil is in the details. Others, led by Susan Collins, want to ensure that eliminating penalties for those who choose not to buy health care insurance won’t seriously disrupt the Federal exchanges. There is a bill on the floor of Congress co-written by Senators Murray and Alexander to do just that. She wants that bill passed before she votes for tax reform. That could happen, or she might accept some other assurances. John McCain wants more spending for the military. In short, while there are no Senators yet unalterably opposed, passage is far from certain. However, every Republican, including those I just mentioned, knows that if nothing happens the party is going to have a very rough time in the 2018 midterm elections. Thus, they are likely to pass something.

Will what’s on the table be as good as Wall Street hopes for? No one really knows. While stocks have been celebrating the entire time since Mr. Trump was elected President, bonds have retreated from their January highs, and the dollar has remained weak against both the euro and the yen. There has been economic growth and corporate profits have emerged from their 2015-2016 recession. But much of the improvement relates to a weak dollar and strength in economies overseas. U.S. growth has picked up a bit over the last two quarters and consumer sentiment is high. However, year-over-year growth remains within the same range it has been in for the past eight years.

The tax bill provides almost $150 billion in annual stimulus over the next decade by increasing both the deficit and the national debt. Most of that stimulus, however, goes to large corporations. For that to trickle down through the overall economy, the companies that benefit from big tax cuts must spend or invest, not simply buy back more stock or pay dividends to shareholders. While there have been indications lately that firms are starting to invest more and spend less money buying back stock, ultimately investment is a response to rising demand. Corporations don’t create their own demand. Building new plants doesn’t create demand; it just creates capacity. Demand comes from consumers. Despite everything you read in the papers, there is some benefit to consumers from the tax bills on the table today, and therefore, there will be some improvement in demand. But with so much of the benefit going to corporations and not to the consumer, how much added growth is in question. I am in the camp that suggests incremental growth will be in the neighborhood of a few tenths of a percentage point, not a few percentage points as President Trump likes to opine. The risks to investors, therefore, is that hope exceeds expectations. While it is too early to come to that conclusion, should the tax bills become law, and Wall Street celebrates with an explosive rally as it did after Trump was elected, the bar might be set too high for significant further gains in the months ahead. But let’s not get too far ahead of ourselves. So far, there is no new tax reform law in place.

Now to Bitcoin. The Bitcoin bulls want to preach that Bitcoin is Gold 2.0, a millennial digital store of value that will replace gold over time. While Bitcoin is called a cryptocurrency, it isn’t a currency in the traditional sense. No one is going to go to the supermarket anytime soon and buy groceries with bitcoin. Bitcoin also isn’t to be confused with an emerging digital technology called blockchain. While it is built on blockchain, Bitcoin, and other forms of digital currency, exist in an open world where the currency itself carries a distinctive ID similar to the serial numbers on your paper money, but the buyers and sellers in a transaction are usually anonymous. While that might make Bitcoin ideal for drug dealers and money launderers, the anonymity is precisely one reason why this won’t ever be a serious currency in its current state. Every currency today is regulated in some fashion and most are stable in value. Most of the currencies that aren’t stable aren’t worth much.

So why is Bitcoin going crazy? Why did Internet stocks go crazy in the late 1990s? Why did casino stocks go crazy a decade ago? Why did Dutch tulips in 1637 sell for more than 10 times the wage of a skilled worker? The answer lies in two words, speculation and greed. Bitcoins are created by “mining” using fast computers to solve complicated algorithms. But the growth of bitcoins outstanding is preset. Thus, as more people mine, the amount of bitcoin they each earn for their efforts declines.

If supply growth is limited, demand growth isn’t. The faster prices rise, the more people want in. Think of the lottery. When the prize approaches hundreds of millions of dollars, more people play. The odds of winning the lottery never change, but the amount one might win does. In the case of bitcoin, when it appears price is only going in one direction, there are more buyers than sellers. Until, one day, there are not enough new buyers and price rapidly goes the other way.

The bulls will tell you this time is different, but that is true for every bubble. Unless you are a drug lord, there really isn’t anything you can do with your bitcoin except sell it. Unlike gold, you can’t even look at it. It doesn’t have a smell and you can’t buy anything (legally) with it, at least not at the moment. Its total value rests on the notion that someone will pay you more than you paid for it yourself. And, by the way, as more and more unsuspecting people buy Bitcoins, you can expect hackers to arrive on the scene to try to steal their bitcoins. Caveat emptor everyone. This story is almost certain to have the same unhappy ending as every other bubble in the past. Obviously, I can’t tell you whether it will go to $20,000 before it crashes. But like every tragic opera, they all die in the end.

Today, Don Cheadle is 53. Howie Mandel is 62. And Vince Scully, the voice of the Brooklyn & Los Angeles Dodgers, turns 90.

James M. Meyer, CFA 610-260-2220

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