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True Threat?

| August 13, 2017
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“Military solutions are now fully in place, locked and loaded, should North Korea act unwisely. Hopefully Kim Jong-Un will find another path!”

 

Donald J. Trump (Friday, August 11th Morning Tweet)

   

Stocks decided to pay attention to the back and forth nuclear rhetoric between North Korea and Donald Trump last week, but what should we make of such bombastic saber rattling between the two impulsive presidents?

  

Sell the Rumor, Buy the News and Vice Versa

It’s long been our thought process that the current bullishness of the U.S. markets has been partially fueled by the expectation that taxes on corporate earnings will be cut to 15%.  Many industries that stand to benefit from this such as healthcare and home-builders have performed particularly well year to date.  However, once we have more clarity on the passage or failure of a tax bill affecting corporate taxes, a selloff is more likely.  In the markets, corporate earnings and more specifically future corporate earnings are more closely tied to future stock performance than any other factor.  Wars and rumors of wars are primarily significant to the extent they affect consumer confidence and future corporate profits.

 

Below are two charts which show how the markets perform when expecting conflict and during the conflict.  As can be seen, once the conflict ensues, most of the damage is already done with the exception of 9/11 attacks which few were anticipating.

  

 

Reuters reported the following about the market’s reaction to the potential conflict:

 

The damage inflicted on world stocks last week by the escalating war of words over North Korea topped $1 trillion on Friday, as investors again took cover in the yen, the Swiss franc, gold and government bonds.

 

This coincided nicely with the ratcheting up of the Mueller investigation and the winding down of earnings season. After ten or eleven consecutive days of quietly grinding higher with virtually no volatility, the markets needed a reason for the selloff.

Last week was only the second week of 2017 in which the S&P 500 dropped over 1%. The average daily change for the US stock market this year was so small you had to go back more than 50 years to 1965 in order to find a more tranquil year. It’s worth noting that we had also hit the top ten starts to the year with the smallest amount of positive 1% days.

Lessons from the "Mad Genius"

Mike Caro in his classic “Book of Poker Tells” informs us that those players who are acting strong typically have a weak hand while those who act weak typically have a strong hand.  The “Mad Genius of Poker” wrote about these tells over 30 years ago and they are generally true today, both in poker and in dealings with politicians.  In today’s world it seems North Korean President Kim Jong-un is definitely “mad” but certainly not a genius.  Many might say Mr. Trump is “mad” and some would consider him a “genius”.  Unfortunately it’s hard to ascertain whether his actions are more predetermined or the product of narcissistic rashness.  So what can we make of the latest war of words between Mr. Trump and the North Korean leader? 

 

“To reach for one's chips before it is one's betting turn betrays a weak hand.”

The North Koreans have been overtly displaying their “military might” by publicizing their advances and parading their weapons in front of the masses. This past week the Washington Post reported that US intelligence believes North Korea now has the capability to put a nuclear warhead on an ICBM and hit something far away by as early as 2018.  They are doubtful the North Korean military has mastered the technology required for the warhead to survive atmospheric re-entry, however.

 

The fact that Kim Jong-un has made such a show of his prowess more likely belies a lack of true strength.  We should be more concerned if they were making an effort to hide their advances.

 

“When a player bets forcefully or with exaggerated gestures, it is usually a bluff.”

Trump’s threats of “fire and fury” to date have been met with war rallies, threats to strike at Guam and the “one thousand fold retribution” of the North Korean military.  Clearly neither leader wishes to back down and lose face.  But the fact that both are so vehemently telegraphing their moves leads to the conclusion that these actions are unlikely.  Unfortunately, games of chicken often end up with both parties unwillingly committed to their mutual destruction.

 

As we see it, the most likely scenario involves the United Nations doing all they can to insure the severe economic sanctions imposed upon North Korea last month are carried out.  China’s failure to uphold the sanctions could in lead to a global trade war in a worst case scenario.  President Trump has already threatened “45% tariffs” on Chinese goods and would more likely carry this through with other U.N. nations potentially following his example in this scenario.

 

We expect it will all blow over and cooler heads will prevail, for the time being.  North Korea is even less likely to survive a cold war than the U.S.S.R., but we likely have not heard the end of Mr. Kim Jong-Un.

  

 

 

Will we see increased volatility? 

Will we be better off buying the dips as we have been for the last year and a half?  Every selloff since February, 2016 has rallied almost immediately as market participants have realized that various political events have little impact on future corporate earnings or could actually lead to increased earnings over time.  August & September continue to be the two worst months to own stocks, tax legislation is on the docket when Congress re-convenes next month and we usually see a correction of at least 10% on an annual basis (some would say we are due).  Currently market breadth is also poor. (less stocks are trading above their 50 day moving average). 

Many of these factors have caused us to embrace a more defensive posture, raising cash and increasing our bond exposure.  Until corporate earnings start to falter, the Federal Reserve raises rates too aggressively or we encounter excessive inflation/deflation we should continue to enjoy healthy stock market appreciation outside of typical corrections.  We cannot experience a "goldilocks" economy forever, but we can enjoy it while it lasts.

 

“When a player bets gently, it is rarely a bluff.”

Most would agree that there is no need for President Trump to provoke or try to verbally intimidate other world leaders.  Some would say that these actions are unproductive unless he wishes to convey himself as a loose cannon that is capable of the most impulsive acts and seeks to use this to his advantage.  Whether Trump is being rash or acting that way to promote this image is better answered by those closer to him.  As Americans we hope it is the latter.   Bluffing is only occasionally successful and I would prefer the “Speak softly and carry a big stick” mantra of Theodore Roosevelt.

 

 

 

Joe D. Franklin, CFP is Founder and President of Franklin Wealth Management, and CEO of Innovative Advisory Partners, a registered investment advisory firm in Hixson, Tennessee. A 20+year industry veteran, he contributes guest articles for Money Magazine and authors the Franklin Backstage Pass blog.  Joe has also been featured in the Wall Street Journal, Kiplinger's Magazine, USA Today and other publications.

   

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