Senate 2020 – Early Handicap

Originally sent to VIXCONTANGO subscribers on December 12th, 2018

With Democrats just having captured a large majority in the House (235 seats), one of the positives for Republicans was that they were able to increase their Senate majority by 2 votes to get to 53. I was expecting Republicans to do a little better, however, and get to 55 by picking up the John McCain seat in Arizona and take the John Tester seat in Montana. Republicans were only able to add seats in Florida, Indiana and North Dakota on the heels of the Kavanaugh hearings and I was expecting them to do better. So I got a negative disappointment here versus my expectations. While my political prognostications are vastly better than most of what you see out there, I still review my failures even as small as they are to see what I got wrong. In the shadows of those marginal surprises is where big new political trends lurk. In particular, what pissed me off to no extent was the loss of the Arizona Senate seat. The GOP most definitely screwed up with Martha McSally who was a weak candidate but I still thought the McCain mafia was going to push her through. But they couldn’t and that is super important because the demographic trends in Arizona don’t get any easier for the GOP over the next 2 years. If Kyrsten Sinema could squeak by in 2018, her clone will trample in 2020.

2019-10-25_162207

 While the map for Democrats was historically difficult in 2018, the script is going to flip in 2020 when the GOP will face a historically difficult map. In 2020, the GOP will defend 22 Senate seats while the Democrats will only defend 12 seats. It is a sea of red up there. Most of Democratic seats up for grabs are in Democratic strongholds such as Oregon, Illinois, Virginia, New Jersey or Massachusetts. The only real question mark for Democrats is the Doug Jones seat in Alabama. On the other hand, Republicans have a very problems in a lot of places. Here is a list of the Republican Senators who won with less than 53% of the vote:

Arizona – Jon Kyl (appointed on McCain’s death and will not run for reelection)

Alaska – Dan Sullivan – 48%

Colorado – Cory Gardner – 48%

Georgia – David Perdue – 53%

Iowa – Joni Ernst – 52%

Kansas – Pat Roberts – 53%

North Carolina – Thom Tillis – 48%

South Dakota – Mike Rounds – 50%

Maine – Susan Collins (state overall votes heavily Democratic)

This is definitely a list of Senate seats that can flip Democratic in 2020. Democrats just won in Arizona and demographically they will only build a bigger lead in this state over the next 2 years. Add Colorado, Georgia and North Carolina to this list of states that are going through a demographic makeover. Iowa and Kansas voted with a decidedly Democratic bent in 2018 at the House level. Some of the shocking victories for Democrats in 2018 were in the Bible Belt. In Maine, we have a unique situation where Susan Collins has made some big votes (most notably for Kavanaugh) which can cost her in what tends to be a very Democratic State otherwise. Maine doesn’t have a single Republican House representative.

If I was to handicap this, this I would say Democrats lose the Doug Jones seat but gain seats in Arizona, Alaska, Colorado, Georgia, Iowa, North Carolina and Maine. This is a net pickup of 6 seats. So Senate goes from 53 seats for GOP to 53 seats for Democrats in 2020. Chuck Schumer had a very mysterious smile the entire time during the “Rumble in the Oval”. The reason why he had the smile is that he knows that Trump’s Senate majority will only last 2 years. And after that the Senate goes back into Democratic hands with 95% probability.

Guess what that means? The Democrats will be digging in their heels big time against Trump. Every trick in the book will be used against him. And if Trump is impeached or loses the 2020 election, with an even bigger Democratic majority in 2020 and 53 Senators, the entire Trump agenda will get erased from the history books. The tax cut, everything. If there are any “deals” or wins for Trump over the next 2 years, they will be all on Democratic terms. Don’t expect Chuck Schumer and Nancy Pelosi to back down on anything. And given the progressive bent of the new incoming Congress, even if anything gets done, I am not sure there will be much gravy in it for Wall Street. Sorry.

Early 2020 Senate Projection: 53 seats for Democrats

The Border Adjustment

Originally sent to VIXCONTANGO subscribers on January 14th, 2017, almost a year before Trump’s Tax Cuts And Jobs Act was signed

New Economic Geography

Ever since the fall of the Berlin Wall on November 9th, 1989, we have lived in the era of Globalism. Many long-standing economic and societal borders fell around the world between the Communist block that encompassed 70% of the civilized world and the Capitalist block that covered the more economically successful remaining 30%. Governments across the world started to build a new world order of international economic cooperation that was going to bring peace and prosperity. A major undertaking like that has a theory behind it and the creator of the theory of Globalism is none other than conservative pariah and liberal idol, Paul Krugman. Paul Krugman is one of the premier economists of our time and an extremely smart individual. And he would have been universally revered if he didn’t compromise his integrity by advocating for unreasonable radical economic solutions and misused his economic integrity in the pursuit of partisanship, thereby becoming a political hack with a limited shelf life.

2019-10-20_051237

Krugman major contributions to the world are 2 academic papers. The first paper is called “International Trade and Income Distribution: A Reconsideration” published in 1979. In it he lays out an economic theory called “New Trade Theory” (NTT). Prior to New Trade Theory, international trade theory emphasized that trade between countries is based on comparative advantage of countries with different characteristics. Saudi Arabia has oil, France has wine and they trade red gold for black gold. While that is still true to an extent, as borders and tariffs fell, international trade started to move differently and the original model couldn’t explain these movements. This is what Krugman’s paper did, explain the new patterns of trade. In it, Krugman observed that a larger share of trade happens between countries with similar characteristics. Why are Japan and the US, trading so much when both economies make the same things – cars, power tools, electronics, computer chips? Krugman says that consumers prefer a diverse choice of brands (expanded selection) and that production factors economies of scale. Consumer preference for diversity explains why you have 20 different car brands, but economies of scale make it so that production is localized. In addition to economies of scale, lower local transportation costs lead to a “home market effect”. A country with large demand for a certain good will produce more than the proportionate world share of the good and will over time become a net exporter of it and that process will kill off production of that good in smaller markets. So production doesn’t occur in all countries in the world but just one or two or three over time. That is why now you only have France and Napa Valley as the only wine producers of major sales consequence. Why only Japan, the US and Germany produce cars. Why only US and Europe produce airplanes. And why China and the US are the only ones making smartphones. This is New Trade Theory. It is very obvious, but it was not so obvious 35 years ago. In that paper Krugman also correctly predicts that while there are economies of scale in production, countries will eventually become “locked into” disadvantageous patterns of trade. Krugman points out that while globalization is a net positive, ultimately globalization turns into hyper-globalization which plays a major role in rising income inequality.

He expands on the concept of hyper-globalization in a paper called “Increasing Returns and Economic Geography” published in the Journal of Political Economy in 1991. In that paper he lays a new economic theory called “New Economic Geography” (NEG). In NEG, the “home market effect” is exacerbated and that results in disadvantageous patters of production inside a country and across economic geographies. Not only is production concentrated in countries, it increasingly becomes concentrated in metropolitan city regions. The regions with most production become more profitable and they then have the ability to attract even more production and kill off production in competing regions. So instead of production being spread evenly around the world, it becomes concentrated in a few countries, regions and cities which become very densely populated and feature higher levels of income. So the world becomes either a high rise city of highly paid professionals or a barren countryside with barns that are falling apart.

2019-10-20_051305

The body mass of all 7 billion people of the world inside the Grand Canyon

That is why if you live in Manhattan you are concerned with the “overpopulation” of the world and if you blow a tire in Fishkill only 50 miles away from Manhattan, you have wait 5 hours for the AAA truck to show up (trust me, it has happened). In other words, if you want to have a good high paying job, move from Detroit to New York. If you want to make money in real estate, sell Detroit, buy Brooklyn. I have personally observed this in my lifetime where landing me in New York was the best thing that ever happened to me professionally. I could always line up at least 2 job offers in the span of a week. That gave me both choice of work and an advantage in salary negotiations. I wanted to live in San Diego originally, but for my skills there were zero jobs there at the time. I looked for months. In New York, I didn’t have enough time to reply to all the job postings posted in a single day. And none of this is a function of how smart I am but simply the relative strength of the economic region.

Needless to say Krugman’s theories have been very prescient, what they have described has become a focal point of international affairs and very deservedly he was awarded a Nobel Prize in 2008. In fact, in his case, even a Nobel Prize is an inadequate reward for his intellectual achievements. What is even weirder is that his theories foresaw the rise of desolate economic regions, the resulting increase in inequality and the rise of political movements to counteract this effect of hyper-globalization. And of course having foreseen it, he has fought the emergence of economic nationalism tooth and nail from the very beginning. What is unfolding right now is his worst nightmare come to life.

In the mind of our leading economists, globalization is really the preferred approach to worldwide economic organization because it leads to larger cross-national economic regions. Larger economic regions result in increased economic activity via trade, result in higher specialization which means higher paying and more interesting jobs and results in efficiencies of scale which results in higher standards of living (people pay less for the same good over time). It is undeniable that they mean well for the world as a whole. There is hardly much to be argued with from a theoretical perspective.

But explain that to an air conditioning mechanic with 20 years of experience who just lost his job and there is no other such job anywhere in the entire country. He has to move to Mexico and learn a new language at 45-years of age in order to receive a lower salary. In the meantime, how is he going to pay for the $100,000 outstanding on his house loan given that his house value just tumbled by $40,000 dollars and if he sells his house, he is $40K in the hole which exceeds his meager savings? Economic theory is great, but the reality of life tends to get in the way of economic perfection.

The main factor that is NOT considered in globalist economic models is the concept of nations. Nations are not organized as such because they have a comparative economic advantage but because they have are a conglomeration of people of similar ethno-centric group, similar religion or simply a militaristic agglomeration. In fact nations exist for all kinds of reasons but economic advantage is not one of them. The reason why economics is not a reason for nation-state organization is because the economics of war, of military conflict, are highly asymmetrical. And have been since the beginning of time. A simple cheap cannon can destroy many houses that took years of effort, materials and investment to build. A nuclear bomb can destroy the combined accomplishments of thousands of years of civilization in a given city in an hour. As such the cheapness of military conflict and its ability to asymmetrically inflict economic damage, is the reason why nations are defined based on military characteristics more than anything else. Economic globalism is therefore a very fragile function of global peace.

Not only is the concept of nations not covered in Krugman’s theories, but also many more mainstream economic considerations such as:

Economic debt and credit levels

If a nation has high debt levels and loses its productive capacity, the leverage speeds the decline of the nation into bankruptcy. A bankrupt nation is therefore not capable to contribute as a consumer to the economic system. So a system with 10 participants, because of NEG becomes a system with only 3 rich participants and 7 bankrupt participants that ceize to be economic units. Production is concentrated but in the long run sales become economically concentrated as well as bankrupt consumers fall off the map.

Lower living standards

When productive capacity in an economy or country is removed, also its ability to pay taxes is removed. As such the citizens of this country experience a lower standard of living as they get less benefits. This not only does not stimulate economic growth it actually eliminates it.

Lack of flexibility in adverse circumstances

If all production is concentrated, during a war it becomes a very simple task to be destroyed quickly by simply eliminating a few important economic units. Decentralization is key component of war and of survival in general. A human can breathe through the nose and through the mouth. In case one thing malfunctions, the other one can take its place. That is why there are 2 eyes, 2 ears, 2 hands and 2 legs. Not because they are useful, but because they are redundant. They provide backup and added resiliency for survival in case the primary mechanisms are attacked or malfunction. Similar concepts apply to complex systems such as economies or computer systems. Centralized globalist economies are thus much more in danger of quick destruction than decentralized ones.

It is perhaps very befuddling for Krugman to witness the age of slow economic growth in the US over the past 20 years. He couldn’t have foreseen that the largest economic power will fall victim to Globalization. After all power should’ve concentrated more and more in the US as it is the dominant producer and the home market effect should’ve enabled that across a number of industries. The problem for an economic theory as always is reality and the lack of inclusion in it of enough important factors. For example, in Krugman’s theories nowhere is there made a reference to taxation regimes. In practically all of the world except the US, consumption is deemed a bad societal characteristic and is thus taxed. Countries with communist lineage love to tax consumption via VAT. Also in non-secular countries, religions often postulate that consumption is unholy or that interest is unholy. Consumption = bad. So the USA is pretty much the only country where consumption is not taxed because it is socially acceptable. So in the WTO, the US is the only country that taxes production and not consumption and everybody else taxes consumption but not production. The net effect is that corporations will choose to produce where they are taxed less and then sell where they are taxed less. Pretty logical choice, right? So corporations will chose to produce outside of the US and sell in the US. Normally, these discrepancies would get fixed by currency adjustment. But what if currencies are not allowed to adjust? What if China pegs its currency to the US dollar? Then the imbalance remains forever and heavily impacts economic activity.

Taxation is one factor that is seriously crimping Krugman’s vision. Others are loss of tax revenue, loss of government benefits, state subsidies and other mercantilist policies and the overall reality that global trade is a shark tank where each actor tries to get as much advantage as they can get and screw the others. The Globalist kumbaya is largely a figment of Krugman’s imagination. Every incomplete or bad theory eventually meets its inglorious demise and so does Krugman’s theory of New Trade and Globalization in 2016. So while Krugman’s theories crumble, the US has to adjust and somehow start collecting the tax revenue it ceded to China and other mercantilist players. How?

Border Adjustment Taxation

Before I delve further I want to make 100% clear one thing. The Border Adjustment IS NOT A TAX. Repeat again. The Border Adjustment IS NOT A TAX OR A TARIFF.

As I go further into the specifics of the House GOP (“The Better Way”) tax plan, it is very important to note that there isn’t a single tax hike anywhere in the plan. There isn’t a single tariff. The price of any good imported in the United States will not go up by a single cent. In other words, $100 of Mexican avocados in the US will still be $100 of avocados after the GOP plan passes, because there will be no additional tax or tariff applied to them. What changes is underneath the surface and is brilliant in its design and simplicity. And yet, it will result in massive amounts of money being put in the government coffers:

2019-10-20_051343

So what is the Border Adjustment?

Eliminate the deduction of imported goods and exempt sales of exported goods.

 That’s it. A simple accounting trick. Anything purchased abroad can no longer be deducted and anything sold abroad is no longer taxable (which is essentially what a territorial regime is). In other words, it makes complete sense even at the most fundamental of levels. If you bought it abroad, this is not economic activity in the USA so therefore why should it show on your US taxes in any form or fashion? Likewise, if something is sold abroad, that is where it gets taxed. What the heck does the US have to do with its sale? In all honesty, it is not even an accounting trick. It is how things should be.

This is the taxation regime of many countries in the WTO already. There is nothing earth shattering here. It is what corporations have always wanted – territorial taxation. Tax the sales where they occur, not where the corporation is headquartered or where the production plant is. In a cloud world, it gets very hard to pinpoint concepts such as headquarters or production plants. A web company with a global software engineering team produces in all 20 countries where it has engineers. Does that mean it has to pay production tax in 20 countries where each dude is? How much value add each dude contributes to the final product? It is a logistical nightmare to figure this out. It is much simpler to simply tax where the sales occur. And that is that. That immediately kills the need for inversions, because being headquartered in the US doesn’t mean you have to share 35% of profits in Saudi Arabia with Uncle Sam anymore. What you sell in Saudi Arabia gets taxed there and that is that.

What does that mean in practice? That means that importers will pay more in taxes as their import costs will not get deducted and what they pay extra in tax will get transferred to exporters who then get a tax credit. Very simple. The imports subsidize the exports. And make exporters more desirable on an after tax basis. No changes for domestic companies. And importers – they have to pay more in tax.

2019-10-20_051356

Source: Kyle Pomerleau, Tax Foundation

The most important thing of this is that prices for consumers will not change one iota because there is no tariff on an additional consumption VAT tax anywhere to be seen. Effectively from a retail sales perspective, the GDP growth projections do not have to change one cent. It is just that being an importer becomes a less profitable business. You know I feel really bad for the Chinese princelings that own the major Chinese import companies in the US. It’s going to put a crimp on their lifestyle. But not much else.

Would the WTO object to this? Here is what the Tax foundations says:

The World Trade Organization generally allows and expects consumption-based taxes (called “indirect taxes”) to be border adjusted. However, it objects to income-style taxes (called “direct taxes”) being border adjusted. So the corporate income tax is considered not eligible for border-adjusted treatment. This is the conventional treatment going back to the 1950s. However, there is a case for treating this tax as an indirect, consumption-based tax. Once a business tax allows full and immediate expensing of capital investment spending, it takes on the nature and tax base of a consumption-based tax.

Brilliant move, right?

Our Early 2018 Election Analysis

Originally sent to VIXCONTANGO subscribers on August 3rd, 2016, three months before the 2018 election

Will Republicans Keep the House?

Politics is a fast moving sport and things can change very quickly. While the map in the Senate remains daunting for Democrats and Republicans are widely expected to keep their majority and even extend it, in the House the picture is far more fluid. As the prime election season is approaching in the next 2-3 months, I will be looking at the political situation more closely – specifically as it relates to the House – at least once a month. Yesterday, I did a review of how things have progressed over the past month and it seems that Democrats have been making a bit of progress on the House front.

To be honest with you, what triggered this review so soon after I sent out my analysis last month is seeing Bannon in the news over the past week. He was on Hannity calling for Republicans to unite together. Trump was recently seen attacking the Koch Network on Twitter. Trump himself has started doing rallies which are broadcast on Fox News almost every day now. That got me thinking – why is Bannon on TV all of a sudden? Didn’t Trump throw him out? Didn’t McConnell brand him a loser and together with Trump cast him out of the party for his “divisive” influence. Why is Bannon out there making a call to arms? Why is Trump campaigning every day again?

Because the Republicans are losing the House.

Democrats have big leads in Voter Registrations & Fundraising

What happens in an election in a given year is largely driven by who shows up at the voting booth. In the US, elections hardly get half the population to vote. The voter turnout for presidential elections is about 55% while the voter turnout during mid-term elections is far far lower at 40%. Basically barely only a third of the country shows up to vote in a mid-term election and then who shows up really drives the result of election.

2019-10-17_160818

2019-10-17_160828

One way to measure potential turnout is voter registration during the primaries. In 2018, the Democratic lead in voter registration is staggering. There are 44.2 million registered Democrats vs 32.5 registered Republicans in 2018. This is a lead of 12 million voters. This is a massive advantage. While most of that comes from California which has an almost 4 million spread, what should be particularly worrisome for Republicans is WHERE ELSE this deficit is coming from. North Carolina is not a good place to be posting a 500K deficit. Pennsylvania is not good place to post 800K deficit. West Virginia (?) is not a good place to have a 128K deficit. Florida is not a good place to have a 200K deficit. Trump won West Virginia by 40 points yet Democrats are leading in registrations there.

The voter registrations together with the fundraising numbers that have come out lately paint a fairly grim picture for Republicans. At this stage in the game, Republican incumbents are raising less money than Democratic incumbents did in 2010 when they held the House. In 2010, 44 incumbent Democrats were outraised by Republicans who then captured their seats in the fall. The GOP picked up 60 seats and flipped the House. In 2018, you have 56 incumbent Republicans who are outraised by their Democratic challengers. Republicans in 2018 are in worse shape from a fundraising perspective than Democrats were in 2010!

Enthusiasm is key in a mid-term election and Democrats are more enthusiastic to come to vote than ever. In 2016, you had only 7 million total Democratic voter registrations. In 2018, you have 14 million new registrations. Double 2016! All of these people woke up really pissed off on November 8th, 2016 and have had rage building inside them for 2 years. This really is not about the economy or anything else, this is about getting your way and what appeared to be a sure thing for them with Hillary slipped away. So in 2018, Democrats are not taking anything for granted and are playing a very organized game. They are getting people to come out to register and vote and they are getting the money. They hope to produce at least one check to Trump’s power by flipping the House. On the other hand, voters of the party in power are generally more complacent, because well – they already hold the power. So the combination of the 2 is why so often you have changes in House leadership during the mid-term elections.

Larry Sabato’s Crystal Ball

I know people will immediately say that he didn’t call Trump in 2016. Nobody else did. But Trump is not on the ballot in 2018. Bannon is not on the ballot in 2018. In 2018, you have a classic McConnell Neocon GOP against insurgent Democrats. The element of voter surprise is this time on the side of Democrats who have registered 61% participation by Democrat Socialists and liberal progressives. In the past, this percentage has been at best 30-35%. So the emotional part of the electorate is more involved on the Democratic side. Back to Larry Sabato and him not calling Trump. Sabato did call previous elections fairly accurately. I looked into his track record and I was very “disappointed” to find out that most of the time he made really good calls. So in a traditional scenario where you don’t have the Brexit/Trump voter out on the rampage screaming against the Obama era, Sabato’s traditional models might yet work. And what does his Crystal Ball says for 2018? He was on TV last week and starting to ever more meekly imply that Democrats might get the upper hand in the House? Why?

Too Many Republican Retirements

First of all, you have 26 Republicans retiring. Politicians retire because they can see that they can’t win their election. You have most of the GOP leadership including Paul Ryan retiring. Basically, every Never Trumper is retiring. The total of 26 retirements is the highest since 2008. As you can see in the chart below, a high number of retirements to one side tends to lead to wins for the other side. For example, in 2008 when 27 Republicans retired, Democrats won 21 seats in the House. If you look at the table below, whenever one party has more than 20 retirements, the other party tends to win a fair number of those seats.

2019-10-17_160837

More interestingly, Sabato has about 200 to 200 solid Democrats vs solid Republicans. And about 35 tossups. All of those 35 tossups (or majority of them) are held by Republicans. Thus Republicans are at the disadvantage of having to defend their seats. Well, guess how many of those Republican seats are in districts that voted for Hillary Clinton in 2016? About 26 of them – most of them are in California and Pennsylvania. And you saw the type of voter registration advantage the Democrats have in California and Pennsylvania. All the Democrats need to do here is split the tossups with Republicans. Which is very conceivable in a year where they have the enthusiasm advantage. And many Republicans that have to answer why they voted for a tax reform that eliminated the SALT. That issue may not be a national issue, but I am sure it is an issue in California, New Jersey and New York.

Republican House members who hold seats that Hillary Clinton carried

2019-10-17_160850

Conclusion

While it is still too early to draw any conclusions about the election, many signs that have pointed to a mid-term win for a given party in the past are this time favoring the Democrats. They have the voter registration advantage, they have fund raising advantage, they have the incumbent retirements advantage, all of the tossup seats are held by Republicans and many of those districts were won by the Democratic candidate in the 2016 Presidential election. In fact, the Generic Congressional Vote poll does a poor job of showing this discrepancy with only a 7% point lead for Democrats. I thought the election of Ocasio-Cortez would be a negative for Democrats but it seems that the opposite is happening. Since her election, polling numbers for Dems have gone up a little bit. So even though Fox News spends a lot of time attacking Democratic Socialism and Ocasio-Cortez, that doesn’t seem to translate into the polls. While initially there was boost in Republican support, that seems to have dissipated over the past month.

2019-10-17_160901

Ultimately my message here is with the market strength over the past month, it seems that the stock market is pricing in zero probability that the Democrats will win the House. That frankly strikes me as very naïve. And goes against every single observable metric out there. The market seems to be in the mode that every poll and every political number is wrong, just because Trump rendered them wrong in 2016. But the reality is that Trump is the exception, not the rule and Trump himself is not on the ballot. Obama was an extremely popular President, yet his personal numbers hardly translated into Congressional seats. The same could be true for Trump. It is very likely that we have a very conventional election where all the conventional polling numbers turn out to be a right. And THAT this year qualifies as the big blindside surprise that nobody is expecting.

In the book “Black Swan”, Nassim Taleb also talks about a White Swan – something that is starting you in the face that you know very well, but yet ignore. Ignoring the very obvious 7% Democratic advantage in the Congressional polls may very well be the White Swan of 2018.

A normally functioning market would assign at least a 50% probability of a House flip and currently the market doesn’t seem to be doing that. Which is very bizarre. Which tells me that markets are about to be blindsided again just like they were during Brexit and the Trump election. If you think Trump has problems with Congress today, you have hardly seen anything if Democrats take over the House. Once Adam Schiff get started with the impeachment proceedings, watch out.

2019-10-17_160915

Our 2018 Election Prediction

Originally sent to VIXCONTANGO subscribers on November 1st, 2018 before the 2018 Election

2019-10-17_155045

2018 Election Prediction

I want to continue the discussion for the Election Scenarios from yesterday. Obviously, after the election I will write up a big guide once we have that very big information, but it is still good to have a model of what will happen and then judge the market’s reaction to the developments from a position of preparedness.

538 (Nate Silver) estimates the probabilities of the GOP keeping the Senate at 85% while the probabilities of the GOP keeping the House at only 15%. He is not alone in that view and polling from various outlets supports roughly tracks these percentages. So I am going to go with them. Polls in this cycle have the traditional oversampling of Democrats we saw in 2016 and thus there is a chance that the GOP will outperform in the House, but oversampling Democrats in 2018 makes more sense than 2016 simply because the GOP is in power. Voters of the minority party tend to be more enthusiastic and come out to vote in higher percentages. For example in 2010, 2012 and 2014, pollsters routinely underestimated GOP turnout and got blindsided by GOP wins 3 times in a row because their polls never accounted for minority party enthusiasm. They are biased only one way – the Democratic way. In 2018, however, they will get lucky because the Democrats are the minority party and enthusiasm skews that way. In other words, polls will accidentally work this year!

2019-10-17_155131

 In the Senate I project the GOP will pick up seats. Only 3 current GOP seats are in question in Nevada and Arizona but the GOP has already basically ensured its majority with projected wins in Texas, Tennessee, North Dakota and Missouri 2 where their candidates hold massive polling leads far beyond the margin of error. If the GOP holds, Nevada and Arizona and gains in Florida, Indiana, Missouri 1 (McCaskill), Montana and a surprise win in New Jersey, you might have a 57 seat GOP Senate! I think the highest probability scenario calls for 54 seats, but recent developments have made me bump my estimates to 55 seats!

Senate Projection: 55 seats for GOP

I really don’t have enough knowledge to decipher the House, but official estimates have the Democrats winning by somewhere between 6-10 seats. If you think GOP will outperform because of Trump, you might think that the GOP would win, but I think Trump will galvanize more progressive Democrats just like Obama galvanized Tea Partiers and thus Democrats will outperform their estimates. I hope I am wrong, but this is what logic tells me.

House Projection: 235 seats for Dems

When you combine the probabilities, almost 75% the chances are for GOP Senate and Dem House. Only about 10% for the other scenarios and a GOP House and Democratic Senate is a practical impossibility. I will start by discussing the lower probability scenarios before I discuss the big one.

Originally sent to VIXCONTANGO subscribers on November 6th, 2018 before the 2018 Election

Key Democratic House Committee Chairs

Since my prediction is for a House win by the Democrats, I am going to start looking into the sector impact of such an event in preparation for my Election Guide email later on tonight and tomorrow morning. I hope I am wrong and the GOP holds the House, but that is a market scenario that does NOT merit a deeper look post-election since we remain on the current Trump-era policies which as we know favor XLF (financials), XLI (industrials), XLE (energy) and XLB (materials). If GOP holds the House, there will be a big market rally in the aftermath of the election. Period full-stop. What is interesting here is what will happen if Democrats take over the House since that represents a change from the status-quo.

The House has the following 2 powers:

  1. It has oversight powers over the executive branch
  2. It originates government spending bills

The Senate, by comparison, has “advice and consent” powers such approving treaties or approving executive branch appointments. In other words, the executive branch has to pass its people past the Senate, but then once they are in office, the House gets to investigate them if they don’t do a good job and “impeach” them. In addition, the ability to originate spending bills basically sets the Fiscal Policy agenda of the United States since Congress really is the one that prints the money (according to MMT). So the House is very, very important for the stock markets. Don’t let the TV pundits fool you. Who holds the House matters… a lot!

The most powerful members of the House sit on “Committees” that oversee various functions. The party that holds the majority selects the “Chair” of each House committee. The House minority party selects a “Ranking Member” which is the highest ranked party member in that committee and generally considered the 2nd in command of that Committee. Congressmen spend their entire careers angling to get a spot on these Committees and ideally one day they all want to become a “Chair” of a committee. These are some of the most important positions in the government of the US. When Congress changes hands, the Ranking Member is usually the one to be promoted and become a “Chair” of the committee in the next Congress. Here I will look through the Ranking Members of note on various important House committee and I will attempt to assess their market impact on select S&P 500 sectors.

 

Ranking Member Sector Impact
Adam Schiff, Intelligence Committee He will have the power to subpoena Trump’s tax returns and then leak them to the media and cause all kind of trouble for the President. He doesn’t have a particular sector impact, but broad market impact because he will have access to the Holy Grail of modern politics – The Trump Tax Returns. Worth a Bear Market all by himself!
Maxine Waters, Financial Services She really needs no introduction. She has been around since the Rodney King riots in the early 90s. Lately she has been inciting the Democratic base to physically intimidate Republican officials everywhere – where they eat, where they sleep, etc. She is one of the more extreme members of the Progressive Left and is often a staple of strong financial regulation. She is a big opponent to Stephen Mnuchin because he didn’t pay her off when he was Chairman of OneWest and she worked really hard to derail his nomination. They are both from LA. Look for her to go after Mnuchin hard (launch an oversight investigation) after the election. In addition, she will be shaking banks for bribes to avoid strong regulatory action. Basically the female Al Sharpton. Banks may pay her off and survive but it is all coming off from the bottom line. Financials (XLF) goes down minimum -10% from current levels. Banks are not expensive on historical basis but if they are regulated by Waters, they could go down below book value. Massive continuous shakedowns are coming.
Al Green, Financial Services,

Oversight and Investigations Subcomittee

 

He has already drafted Trump articles of impeachment and is in the key Oversight position on the Financial Services committee. He is the tip of the spear and he is going after Mnuchin and banks hard. He is going after Trump hard. I don’t think Mnuchin survives as a Treasury Secretary if Democrats win the House. I think he will be gone before the year turns over. But get ready to see a lot of this guy and his brand of extremism.
Elijah Cummings, Oversight and Government Reform He has been discussed in this newsletter as an author of the Sanders-Cummings Drug Price Control bill which Trump at some point considered. If Democrats win the House, that bill will gain big traction. As I mentioned in the past newsletters passing that bill is a $500 billion boost to the US economy as lower drug prices directly benefit US consumers. However, it affects the Health Care (XLV) industry negatively as it crimps their record profitability. This bill is worth at least -20% loss for the XLV at the expense of higher GDP growth in the US. XLY (consumer) and XLP (staples), XRT (retail) are the sectors to benefit disproportionately from this bill. I personally like Elijah Cummings a lot, he is a great American.
Stacey Plaskett, Oversight, Energy and Environment Subcomittee This is going to be the lady trying to make Rick Perry (Secretary of Energy) and Scott Priutt (Environmental Protection Agency) lives miserable. In particular, there is no doubt that oversight investigation of Scott Priutt will be launched. Big Energy has a lot to lose here and this is going be costing them at least -10% in market cap for the XLE (energy), if not more. If oil prices continue to tumble, a Democratic held house is not going to help Big Energy names like Exxon Mobil or Chevron at all. Plaskett is a long time New York lawyer who worked in a high position bringing down Big Tobacco in her past. Her boss Larry Thompson was replaced by James Comey at the Department of Justice. Taking down big old-school industries is her specialty. Her only private job has been at the United Health Group. Long story short, she will be a pain for Big Energy because she is not dependent on them.
Jan Schakowsky, Energy & Commerce, Digitial Commerce Subcomittee

 

Famous for saying during the Facebook interrogations that “It is clear the self-regulation at social media does not work”. Strong proponent of having at least the European GDPR regulation passed in the US. She is expected to come down hard on social media. Social media has been selling off and will continue to selloff as there is more or less bipartisan consent that social media is now important enough to be regulated by the government. This lady is a Chicago hard-liner on the issue and she might fight herself with much backing from Trump Republicans in the new Congress. She takes off at least -10% from the XLC (media) market cap. Probably affects Apple and the XLK (technology) market cap as well.
Richard Neal, Ways and Means Subcomittee Hard to get a read on this guy. He is a Massachusetts liberal who doesn’t like the AMT (alternative minimum tax). He is totally in the “what the f—“ category. Voted against the Bush tax cuts because they would put more people in the AMT category?!? He is in favor of simplifying the tax code and getting the rich to pay their fair share. But not through AMT, apparently. He voted against NAFTA and voted against bill that would give the President more authority on Trade. So he could be a key person that would block Trump’s trade deals if there are any with China, Mexico and other countries. His market impact is across the board and if he goes after preferential treatment of dividends and interest payments in the tax code, watch the market selloff fast. He doesn’t have a sector impact, he has broad market impact. If Trump “simplifies” the tax code the way Democrats want, watch stocks knock go into a bear market fast.
John Lewis, Ways and Means, Oversight Committee This is the guy that is going to ask where the repatriations are – which is about $250 billion in SPX profits which are still unreported. He is in position to launch an investigation into the IRS and Treasury to determine why they aren’t collecting repatriations and who issued the rule that delayed repatriations. Trump insulted him and his payback could be to go after Mnuchin hard and then whoever comes after Mnuchin. Whenever you hear the word “oversight”, that means able to launch investigations of the executive branch. In any case, he has the ability to knock off about $10 per share of GAAP EPS for the SPX. Or roughly 250 points.

As we can see here, the promotion of these folks will have significant negative impact for XLK (technology), XLF (financials), XLV (health care), XLC (media), XLE (energy) and XLB (materials). The only sectors to benefit are potentially XLY (consumer discretionary) and XLP (consumer staples). Unfortunately, the negatively affected sectors represent about 65% of the SPX. If we assume a -10% move in those post-election while the other 35% gain some on rotation, it is not hard to come up with an additional -7% in the SPX which will send us right at the 2450 target that I have for 2018. Democratic House led investigations and anti-business (but very popular among Americans) spending bills will help contract the SPX multiple right to where it should be. Below 20. For sub 10% growth next year, we definitely should not be trading at above 21 GAAP PE trailing multiple like we are today, but much lower.

Long story short, it is very hard for me to envision a big market rally into year-end if the Democrats win the House. As the market discovers the agenda and the background of the new Committee Chairs, I don’t think investors will be happy at all. At the very least, they won’t be willing to overpay for a dollar of earnings the way they did with a Trump led total GOP control of the US government.

Our 2016 Election Prediction

Originally sent to VIXCONTANGO subscribers on November 5th, 2016 before the 2016 Election

2016 Election Prediction

And finally, my election prediction. I don’t have to do that, but why not have some fun. Based on 37 million early votes already cast, we know that black vote is down 7% compared to 2012. Based on correcting the polls for Democratic oversampling, I have come up with a couple of scenarios. One is a very conservative (for Trump) projection and unfortunately Hillary Clinton’s worst nightmare and her best case scenario – losing in a squaker with the House of Republicans casting the deciding vote. Based on latest oversampled polling and early voting in Ohio, Florida, North Carolina and Nevada are already in the bag for Trump. For example in 2012, Republicans went into election day in North Carolina down 450,000 votes – the lead was 48% to 32% into election day. This year? 42% to 31%. Florida – in 2012 they led 43% to 40% in early voting. This year 33% to 33%. In almost every state, democratic turnout is substantially down compared to 2012 while the Republicans is at minimum the same. So removing the oversampling margin from polls makes sense. When you do that, Trump leads both nationally and in most states that are considered “toss up”. And he actually turns Democratic leaning states into “toss up”. So the other scenario I have is a best case scenario where Trump is able to flip Virginia, Pennsylvania, Michigan and Colorado.

The real question in this election is how is Clinton going to overcome Trump’s Rust Belt state firewall? It looks increasingly likely that she will not be able to pull that off.

Best Case for Democrats

Clinton: 269

Trump: 269

2019-10-17_154323

Best Case for Republicans

Clinton: 211

Trump: 327

2019-10-17_154333