Why August May Not Be So Calm; Here's What Bears Watching

By Kevin Freeman
July 28, 2017Jul 28, 2017

Historically, people have watched the stock market as a proxy for the mood and circumstances of our nation. So far this year, the stock market has demonstrated historically low volatility. Of course, it is not uncommon for there to be dull days in the summer months. Looking around the world, however, things are far from dull. In fact, there are many issues where things are heating up faster than the weather. Despite this, the financial markets have been unusually calm, so calm in fact that volatility measured by the VIX remains near all-time lows. The last time it was this low was in 1993, almost a quarter century ago.

Keep in mind that this Blog DOES NOT provide investment advice. We are not in any way sharing what you should or should not do with your money. But, it is interesting to note the extraordinary divergence between how the stock market is acting in relation to what subjectively we are experiencing in the real world. We are not trying to scare you, just inform you regarding some of the things that seem to be in the world's pressure cooker. At the moment, our list of near-term concerns is near an all-time high in number. These are things that may simply go "bump in the night" to little effect. Or they could be very serious issues that will be addressed by hard choices and real consequences. You be the judge.

The following is a sampling of things on our radar. It is far from comprehensive and presented in no particular order.

Political Turmoil

It wasn't that long ago that the market was rising steadily BECAUSE President Trump had been elected and the market was poised to benefit from lower taxes, a repeal of Obamacare, a massive infrastructure package, and true regulatory reform. Now, some analysts are pondering if the market will keep rising in spite of the Trump Presidency. While we have seen some tremendous progress in the regulatory arena, especially where the Executive Branch holds clear authority, the Obamacare repeal, infrastructure package, and tax reform have yet to materialize.

From Day One there were unsubstantiated accusations against the President regarding Russian collusion followed by threats of impeachment. These voices have only grown louder. It really is pretty extraordinary given the fact that President Trump has barely been in office just half a year. Nevertheless, the political opposition is fierce and determined. We actually warned about this in a series of Blog posts as shown below:

Post Inauguration Analysis Part Two: The Domestic War on Trump

Post Inauguration Analysis Part Three: The Deep State War on Trump

Post Inauguration Analysis Part Four: The Globalist War on Trump

You can go back and read each post to see the amazing array of forces lined up against the President. At least this part has played out as we expected. We thought the media would be biased and that has proven out. What the media has been ignoring, however, are some incredible stories on the other side. For example, it was reported today that Russia was behind the famous (now proven to be false) Trump Dossier. What's so incredible about this is that now the connections between the DNC and Russian interference now appear at least as great as any connections with the Trump team. Even the much ballyhooed meeting with Donald Trump, Jr. had Russian and DNC fingerprints making it look more like attempted entrapment than malfeasance.

The second largely ignored story this week has to do with the DNC and Democrat leaders employing a Pakistani IT team that appears very suspicious, especially in light of recent charges. When this story is fully unwound, we may know how and why the DNC was hacked. To catch up, check out these two articles:

Democrat IT Spy Tries To Run To Pakistan: We Connect Some Dots For You

Democrat IT Spy Tries To Run To Pakistan: We Connect More Dots For You

We also have an unprecedented blocking of Trump nominees for various positions:

"In the first six months of President Trump's administration, he made 257 nominations to important judicial and administration positions, yet the Senate confirmed only 55 of these nominees. These confirmation delays result mostly from Democrats putting up roadblocks on even the most non-controversial nominees and insisting that Republicans file cloture on the majority of nominations. In the first six months of President Obama's term, the Senate confirmed 206 of his nominees. All but a few Obama nominees were confirmed without a roll call vote and without needing to go through the time-consuming cloture process. They were confirmed using fast-track procedures – voice vote and unanimous consent. In stark contrast, just five of President Trump's nominees were confirmed using fast-track procedures, and 34 of them were confirmed only after filing cloture."

Bottom line: A political Civil War is underway. President Trump fired a political bazooka when he challenged the LGBTQ(XYZ) crowd when he announced a transgender ban for the military. What does this mean? The political stakes just went higher. We do not believe August will calm this storm.

Iran Missile

The Iranians launched a missile into space yesterday. Does this mean they are preparing communications satellites for orbit? Or, are they looking for ways to orbit a small nuclear device that could produce an EMP and wipe out our electric grid? The reality is we do not know and that is concerning. We do believe, however, that this activity is a violation of UN Resolutions and their agreements. If the market begins to see Iran as a nearer-term threat, this will produce serious unrest.

North Korea Test

North Korea surprised many in the intelligence community on July 4th with a successful advanced missile test. Quoting from the New York Times:

But North Korea reaffirmed Wednesday that it would never deviate from its determination to bolster its nuclear and missile abilities as long as the United States' "hostile policy" and "nuclear threat" persisted.

The North's state-run Korean Central News Agency said its new intercontinental ballistic missile, the Hwasong-14, was capable of hitting the "heart of the United States" with "large heavy nuclear warheads." The launch, according to the agency, successfully tested the functions of the missile's two propulsive stages and the warhead's ability to endure the intense heat and vibrations as it entered the earth's atmosphere.

When we wrote this section yesterday, all indications pointed to another test coming soon. Now, while finishing up, we get word that another ICBM test did take place. This missile got remarkably close to the Japanese coastline. Clearly, North Korea is not planning to take the summer off with major missile tests in both June and July.

We have already restricted American travel to North Korea. People believe that a war may be coming. Without some American intervention, we run the risk of North Korea getting a nuclear missile capable of hitting the United States. Or, as with Iran, the risk is of an EMP weapon capable of wiping out our power grid. Of course, intervention would be dangerous and costly as well. It risks involving China. And there is no doubt the Chinese are preparing. No option seems very attractive at this point unless we can get China to intervene on our behalf in North Korea (which seems increasingly unlikely).

The Middle East Conflict

There is a major clash building in the Middle East. The sides have squared off and involve Egypt, Saudi Arabia, Bahrain, the UAE on one side with Qatar, Turkey, Syria, and Iran on the other. This is not a traditional Shia/Sunni framework. Rather, the battle lines are really drawn over support for the Muslim Brotherhood or other goals with Sharia supremacy intentions. Of course, there are plenty of reasons to suspect Saudi sincerity in any anti-Sharia dominance effort (given their long support for it). In this case, however, the conflict seems to have started with Qatar's foundational support for the Arab Spring that threatened Saudi interests and overall Western ties. The Egyptian government in particular knows the dangers of the Muslim Brotherhood and seems committed to stamping out their influence.

The building alliance between Turkey, Qatar, and Iran is increasingly worrisome. Turkey appears to be committed to an Islamization path that once led to the atrocity of the Armenian genocide and added serious fuel to the fires of the first World WarTurkey is supposed to be an ally in NATO which explains in part why Russia is meddling in all of thisIran is, well, being Iran, which is very bad.

A complicating factor is our massive military base in Qatar. This puts America in a conflicted position. As a result, General Mattis and Secretary Tillerson face a very awkward set of interests given President Trump's clear support for driving out the Muslim Brotherhood. Perhaps the best answer would be to declare the Muslim Brotherhood to be a terrorist group as other Arab nations have done.

In addition to this, there is also the battle over holy sites in Jerusalem. That adds a whole other dimension that could flare up into a Middle East conflict.

Regardless, this is a simmering potential conflict that could involve global energy supplies and much more. As one example, a serious engagement would create massive numbers of Middle Eastern refugees that would make the millions from Syria seem like a trickle compared to a flood. August may pass peacefully the Middle East. But keep in mind the potential for unrest with potent implications.

Venezuela's Collapse

In our last post, we discussed the Venezuela crisis and the implications for America. It's gotten worse even over the past week. We've pulled American personnel from our embassy there as a result. One thing is certain, it will not be solved quickly.

Chinese Debt Worries

Moody's recently downgraded Chinese debt and pointed to a host of concerns. It is clear that the Chinese have a lot of debt, approaching 300% of GDP. And a good portion of that is bad debt. This is unsustainable. The world has depended on Chinese growth and that will falter at some point. The Moody's downgrade complicates matters as it will make it harder to maintain the illusion of excessive growth. Worse still, the Chinese perceive the Moody's downgrade as an act of Economic War by the United States. That is how the authors of Unrestricted Warfare characterized the ratings downgrades by S&P and Moody's in 1997 that precipitated the Asian Currency Crisis. All of this is happening in the context of a possible trade war.

We warned last year that you should Beware a Wounded Dragon. What we said then is even more true today.

The Risk of a Massive Cyber Attack

There is no way to do justice to this issue in a single Blog let alone a portion of one. And, the reality is that this is an ongoing issue that will simply increase over time. There could be a systemic attack that wipes out the power grid and we know Russia has been cyber weapons testing to that effect with Ukraine. And the Russians have recently been caught probing our power grid. There could be smaller attacks that prick the economy as North Korea has done. There could be massive assaults in conjunction with more traditional warfare.

One recent development, however, happened on July 3rd just before our holiday. On that day very unusual activity happened in the NASDAQ that they attributed to a "glitch." We find such glitches to be rather suspicious. Apparently so did Cameron Colquhoun of WIRED UK:

Just before 12.30pm local time, the world's biggest stock exchange, Nasdaq, was displaying the stock prices of Amazon, Microsoft, Apple, and more than a dozen other companies at same price; $123.47. For both Amazon and Google, the companies had apparently just lost 87 per cent of their market value. For Microsoft, the company was briefly valued at $1 trillion.

The cause? Nasdaq claimed that "erroneous third party test data" was behind the wild swings in stock prices. Whilst we should take Nasdaq at its word – that this was a simple error – it is vital to remember that Nasdaq had no other choice. Communicating any kind of hack or security breach would trigger a major market incident and, potentially, a financial crash similar to that of 2008. It is, nevertheless, incumbent to consider the alternatives, and explore the possibility that the 3 July resetting of share prices was a deliberate act . . .

The Nasdaq stock exchange has long been a target for nation states. Back in 2010, stories emerged that Nasdaq had been penetrated by Russian intelligence, and a subsequent investigation revealed the stock exchange's IT setup was a "dirty swamp". Several different groups, from nation-states to criminals, were operating freely within Nasdaq's computer systems. A high ranking US intelligence official later confirmed: "We've seen a nation-state gain access to at least one of our stock exchanges."

In China, there is also some evidence that the People's Liberation Army (PLA) sees the stock market as a legitimate target. In 1999 two PLA generals published "Unrestricted Warfare", outlining a strategy in which a weaker power like China could use new aspects of warfare to cripple the more powerful United States. Amongst other forms of economic warfare, the book advocates the use of manmade stock market crashes as legitimate weapons.

Alongside Russia and China, the two most obvious candidates for the 3 July glitch, there is a third. A few hours after the $123.47 glitch occurred, North Korea launched a test of its first intercontinental ballistic missile (ICBM), attracting worldwide media attention. Threatened with US airstrikes and a possible invasion, North Korea may force the US to pause for thought via a warning shot on the American financial system. From Sony to the NHS, hackers linked to North Korea have a formidable track record.

[To CONTINUE READING this article at WIRED]

We have discussed this risk repeatedly but it was heartening to see WIRED cover it (especially as they referenced Unrestricted Warfare). Cameron Colquhoun also has covered the risk of a massive cyber-led campaign that could be aimed at our financial markets:

Our financial system is dependent on trust, openness and reliable information – areas that Russian intelligence excels in undermining. It is worth noting the SVR has an entire directorate dedicated to economic espionage. Recently, Russia has combined both human agents and hackers based abroad to understand and destabilise Western financial markets. In 2016, Evgeny Buyakov pleaded guilty to FBI prosecutors that he was working for the SVR'S ‘MS' (active measures) Directorate and sought intelligence on market destabilisation strategies. In 2010, the Securities and Exchange Commission found a Russian trading firm was artificially manipulating stock prices using what it called a "hack, pump and dump scheme"  …

The most concerning scenario is that of Russia deploying cyber weapons against stock exchanges and banking systems. Stock markets in London and New York trade almost entirely using algorithms operating at the speed of light – known as high-frequency trading, or HFT. Global banking depends on the proper functioning of these algorithms, but, like any computer program, they can be manipulated, repurposed or deleted. These systems are so complex nobody can accurately model how they will react or respond to manipulation or freak events. The erroneous and uncontrollable behaviour of trading algorithms – known as flash crashes – are regular occurrences in many stock markets. Critically, there are few human stockbrokers left, leaving the financial world with no backup if the markets were manipulated or wiped.

Russia thrives on exploiting such weaknesses. In 2010, highly advanced cyberattack code was found on the world's second-largest stock exchange, NASDAQ, and subsequent investigations believed Russia was the likely culprit. During 2014, the Warsaw Stock Exchange was hacked by a Russian group false-flagging as "cyber-jihadists". As a former cyberintelligence professional myself, I would expect Russia to have developed the capability to trigger financial collapse by using cyber weapons against stock markets in Europe and North America. This is a view shared by a former director of the US National Security Agency, Keith B Alexander, who warned that a cyber-attack on Wall Street would "take down the US economy… it would be very difficult to see or stop". Despite spending millions on cyber defence, global banks are no match for an advanced cyberattack from a nation state like Russia. One high-ranking US Intelligence official recently admitted "We've seen a nation-state gain access to at least one of our stock exchanges… and it's not crystal clear what their final objective is…"

[To CONTINUE READING this article at WIRED]

Again, Colquhoun "gets it." The markets have ignored this risk. In fact, it was mentioned specifically by General Keith Alexander as he headed the NSA and was interviewed by 60 Minutes. A Forbes reporter who saw the interview wrote"If this revelation is widely discussed tomorrow morning, it could very well have a serious negative effect on stock prices." Of course, the risk has risen since then but so have stock prices. Clearly the market is ignoring the risk.

The reality is that Russia could achieve a similar impact on our stock market without interfering in reported stock prices simply by falsifying financial information. Such a campaign would sow serious distrust in market data and likely move share prices lower. The less you can rely on information, the less valuable share prices become.

All of this happens in the context of worsening relations with Russia, China, North Korea, and Iran. Each of these nations have substantive cyber capabilities. One example of brewing troubles came today as Russia ordered the United States to cut its diplomatic staff in response to our imposing further sanctions. A cyber attack is clearly something that must be considered.

Budget Battles and the Risk of a Government Shutdown

The Treasury Department should officially run out of money to pay bills by October according to the Congressional Budget Office. Unless the debt ceiling is extended, this will result in a massive budget battle and threat of government shutdown. Goldman Sachs had once estimated the odds of a government shutdown to be "one in three" when this was first discussed in conjunction with the May budget debates. But they were clear in saying that the odds for an October shutdown were far greater. Now, Bloomberg is reporting that the risks are increasing further, tied to a battle over funding the President's border wall. If accurate, this risk is substantive.

The last time we had such a budget battle and shutdown was in October 2013. The negative impact on markets might be greatest when the market has been advancing and the complacency is shattered by a serious and prolonged budget battle. Historically, however, shutdowns have not been a huge factor in market returns. Would this time be different? Maybe. One of the concerns is that the last shutdown gave the Chinese reason to want to de-Americanize the world. From The Washington Times in October 2013:

China is taking advantage of the government shutdown and budget crisis on Capitol Hill to push for more favor on the world stage, telling other nations that relying on America to lead in the coming decades would be folly. "It is perhaps a good time for the befuddled world to start considering building a de-Americanized world," Chinese news suggested, The Guardian reported. The cited reasons: America's government, economics and leadership were in shambles, China authorities said in the official state-run news agency, Xinhua.

[To CONTINUE READING this article at The Washington Times]

That sentiment has increased. They may find more allies if a shutdown now rankles the global economy, especially in context of everything else happening. While a short government shutdown might not have a long-term impact by itself, it could trigger other issues which would have a profound effect.

The Context of Fed Unwinding

One of the powerful underpinnings of the stock market over the past eight years has been a very aggressive Federal Reserve that has dramatically expanded its balance sheet (as shown in the chart from Byron Wien). [You should notice that Fed activity continued steadily upward during 2013 even as the budget drama played out.]

Now, of course, the Federal Reserve has made it clear that they will be reducing the size of their balance sheet. While the July meeting put interest rate changes on hold, there is an expectation they will start unloading assets in September. Markets typically move in anticipation of trends and any of the other risks we have identified coupled with dread over the Fed might trigger a reaction. And, other Central Banks around the world may need to trim their holdings fairly soon as well. Of course, even being aware of this, noted analyst Byron Wien still anticipates a good market for the rest of the year.

We've covered a lot of risk areas but keep in mind that none of these may impact the public consciousness. There are plenty of time periods during which the stock market climbed the proverbial "Wall of Worry." And, as we shared, this Blog is NOT intended to provide any form of investment advice whatsoever. But we felt it important to draw attention to the stark contrast between the market's apparent complacency and what could happen in the real world. And keep in mind that this is just an abbreviated list.