Jim Ricard is an economist that I admire. He writes for Agora financial, a private forecasting publication. Recently he described how he thinks the next correction will take place and how he thinks about the general economy associated with that correction…
He calls his model – the REACTION model. I found it intriguing and therefore I decided to describe it here in my publication. I would not do this unless I thought that there were insights in this model that more people should understand.
US economy today
The facts about US economy are disturbing –
- The debt to GDP GDP ratio is at a historical high
- It was 35% during trial. Ronald Reagan’s presidency (January 1981).
- o It is currently 105% during Donald Trump’s presidency (January 2017)
- Trump’s first year in office will show deficit spending, which is spending in excess of income •
- The national debt today is $21 trillion •
- The control variable on all spending is the attitude of the Congress, regardless of party control. o
- Congress has been acclimated to many years of Democratic control and spending, which virtually never looked at the debt but just looked at what they wanted to accomplish. o Under Reagan, the military rebuilt from Carter and the debt to GDP ratio became 55% o
- Deficit trends are much a product of the White House wish list as they are congressional priorities and irresponsible actions
Trump’s tax cuts
A big source of confusion exists on the debt and deficits associated with Trump tax cut. The confusion is principally focused on what the corporations will do with the windfall of tax relief they just received.
Corporations had $4 trillion in offshore profits that had not been taxed. The law used to say that you do not have to declare those profits until you bring them on shore into the United States. As a result, they kept them offshore and invested them offshore but never had any taxes on them. These U.S. taxes were as high as 39.5%. After the new tax law, the taxes fall to 22%. Most corporations will take advantage of this and bring the foreign profits back to the United States.
The question remains, is how they will spend it. These profit reparations have occurred about every five years. Historically, the corporations have used these monies as dividends and big bonuses. Little has gone into actual investment, which would boost the economy. Trump has stated that he expects this money to go into investment to boost the economy. Some companies have agreed but most are silent. It will remain to be seen over time what actually occurs. Trump is counting on new jobs based on new investments and a boost in the economy. Will it happen? Only time will tell.
The most significant change in the law on the new taxation bill which has not been discussed in the press is that companies in the future will never have their offshore earnings taxed. This is very significant. It treats corporations different from individuals. This is not good for the United States and will push the US closer to that status of Greece.
Most forecasters are predicting a major economic correction ahead that will affect the whole economy including the stock market. They base this on their view of the last five-year’s performance in corporate profit growth, housing sales, unemployment and debt for individuals and the government sad well as P/E ratios in the market not supported by earnings Further they note
- Stocks have been artificially driven higher by the banks who were supplied the money by the central bank in programs such as quantitative easing. •
- The sequester for defense still exists, although indications are that it is going to be dropped. •
- Unemployment is still high and food stamps are still sitting at 50 million people. •
- The resistance group in the government, the Democratic Party and the press, fight everything that Trump tries to stimulate the economy. •
- Student loan debt stands at $1.5 trillion. It is a major drag on future productive sources of people in this nation. It stands in the way of household formation and purchase of household items.
In summary, many forecasters predict a major drop in the economy and the market and at times as high as 60%, but none are predicting when this will occur. Just saying it is imminent.
Jim Ricard’s REACTION model
The big question for you, my readers, is not whether the correction will occur. But when will it occur and will you be able to detect that it is occurring before it hurts you. As I said Jim Ricard’s REACTION model makes a lot of sense to me. Therefore, I pass it off to you.
Ricard models his reaction model after the Kubler Ross behavior model as to how people deal with grief. The five stages of grief are denial, anger, bargaining, depression, and acceptance.
- Denial – in denial. The individual learns of the bad news but believes it to be mistaken and clings to a false reality. •
- Anger- denial fades, but the new reality is met with anger and claims, “it’s not fair”. •
- Bargaining- the individual hopes to avoid unpleasant outcomes by offering something in return. •
- Depression – individual accepts a result, but becomes withdrawn, recluse or sullen •
- Acceptance- the individual adjusts to the new reality and decides to move forward with a sense. “This is going to work out okay”.
The REACTION world has five stages of financial collapse. They are repricing, acceleration, transmission, irrationality and oblivion.
Repricing – a market meltdown will begin with a rapid repricing of an asset class. One example is what happened in the US dollars/Great Britain Pound after the BREXIT vote. The GBP fell 13% against the dollar in hours on June 23, 2016 (the 1.49 to a $1.30}. The market and the prime movers in the British government crashed into the reality of facts – British citizens wanted out… This was an extraordinary price move. There are other examples of pricing based upon new perceptions of the existing reality. One example is the devaluation of Thai bot that led to the immediate reevaluation of currencies in Malaysia, Indonesia, South Korea, Russia and Brazil. The reevaluation of a local currency caused the sudden changes in international currencies.
Acceleration – this happens when repricing overshoots the new reality and continues using momentum. That momentum is based upon margin, leverage and stop losses. Leverage by barring and provides the event of gain or loss. Once sensed, banks want immediate collateral protection for themselves in the case that traders go out of business. This causes margin calls. On October 29, 1987, black Monday, the Dow Jones fell 22.6%. Most of the selling came from automated (portfolio insurance) programs. Margin calls can only be made with high quality collateral such as cash or treasury bills. Transmission – this occurs when disruptions in one market spread to other markets, which seem unrelated with the initial market. “Contagion” and “spillover” are other names for transmission.
A transmission occurs if yhe markets are highly correlated. A correlation greater than 0.5 is considered strong. Prior to 2008, US stock market and the Japanese Nikkei had a correlation of 0.3 or a weak correlation. After 2008, they had a correlation close to one. Market panic was what caused the correlation to change from 0.3 to 1.0. During 2008, margin calls on traders forced them to sell Japanese stocks in order to meet the margin calls. This transmitted poor liquidity from the US to Japanese markets and occurred almost instantly. Irrationality- during a financial panic, everyone wants their money back. During panic, investors want to convert everything into money. During this stage, the only thing that matters is cash.
In the 2008 crash, banks and regulators guaranteed bank deposits in money markets funds to make the update. These accents seem more like money. Action such as this tends to stop the panic. Investors feel liquid again. Today we have a fed with $4 trillion in debt. Other central banks are similarly leveraged. It is likely that the IMF with the SDR’s is the only financial institution strong enough to get the job of legal education done. The US dollar will suffer. The official response function in the next panic will be to use SDRs from the IMF for liquidity. If that fails all banks account at banks and brokerage traders will be frozen. The closing accounts will lead to the last stage. Oblivion-during a financial panic, “everyone wants his money back.” During panic, investors want to convert everything into money. During this stage, the only thing that matters is cash.
In the 2008 crash, banks and regulators guaranteed bank deposits in money market funds to make these assets more like “money”. Action such as this tends to stem the panic. Investors feal liquid again. Today we have a FED with $4 trillion in debt. Other central banks are similarly leveraged. It is likely that the IMF with the SDR’s is the only financial institution strong enough to get the job of legal liquefaction done. US dollar will suffer The official response function in the next panic will be to use SDR’s from the IMF for liquidity. If that fails, all banks accounts at the bank and the brokerage houses will be frozen. The closing accounts will lead to the last stage. This is a complete systemic failure of markets.
They will cease to function. A dark age will then occur. After the fall of the Roman Empire, the dark ages occurred. Each Dark Age lasts for several centuries. It lasted from 500 – 800 A.D. after the Roman Empire failed. Extreme collapse does happen. In 1914, the New York Stock Exchange closed for five months. In 1933, banks closed for eight days The solution for the individual is to have assets that cannot be frozen, closed, hacked or stolen by the government. This includes assets such as physical cash, land, fine art, physical gold, physical silver and ownership of businesses where you know the entrepreneur.
How do you apply REACTION – the model has powerful explanatory powers to aid you in understanding financial shocks and panics. Some panics stay within the national boundaries with no transmission. Consider Argentina in 1999 – 2000. Raven publishing will stay informed in the months ahead and assess whether early-stage panics have the potential to spin into irrationality and oblivion. We will alert you. Remember, gold recovers faster after truncation. Further, stocks are currently inflated. In 2008, Gold recovered to $1809 per ounce by September 2011. This is 150% recovery in three years. The message here is to buy and have some physical gold prior to the crash.