Many remember the old favorite show, Johnny Carson. At the start of the show Ed McMahon used to say, “What have we got for her Johnny?” Along with this Carson would often call upon his Swamy- Carnac The Magnificent. Often times I am accused of trying to be a sort of Carnac. I don’t profess to be this clairvoyant nor this humorous, but I do try and point out facts and thoughts in a more enjoyable manner!
This week, I would like to touch on the very short-term, namely the action of last week and specifically the pullback that began last Thursday. This has continued into Friday and Monday of this week. Then the things that are mostly considered negative by most, namely: tariffs, immigration, and DOGE added to the emotional construct. These are the things that seem to sort of be keeping investors up at night right now.
Did last Thursday and Friday’s Poor Response Ruin the Bullish Setup that I showed pictures of in last week’s note? The stock market got off to a poor start Thursday, and, while it did partially recover, the session was a disappointing response after the S&P 500 broke out to a new all-time high on Wednesday. See the exact price action below. It is quite clear in the picture below the extent of the pullback. As can be seen back in September, October and December, this is not an uncommon occurrence.
That led to several people reaching out to ask if anything had changed with respect to the market’s overall potential. In short, no I don’t think a couple of down days is enough to negate the setup. The overall point changes on the indexes may seem large, but since the indexes are at pretty big numbers, it is better to focus on the overall price levels and the percentage change. This is why the picture above is important to digest. As I had stated in previous notes, these kinds of pullbacks of the 5-10% variety are quite common. Ideally, any time a breakout occurs we want to see follow-through and an acceleration higher away from the breakout point. That indicates that the break is prompting more buyers to step in and enter at higher prices rather than sellers using the higher prices to unload their existing stock. When a breakout is soon followed by the price retreating back down into its former range, it’s never an encouraging sign, though like with all things related to the market, perfect textbook action does not always occur. The action on Thursday, Friday and Monday clearly don’t resonate as a positive. So now I want to quantify the unknowns in terms that at least make them somewhat measurable.
Inflation, Tariffs, Immigration, DOGE, and Peace
I have called inflation “political kryptonite” because it is so damaging to politicians and investor psyche. Clearly, inflation played a role in the 2024 election. So now that President Trump sits in the Oval Office, his opponents have been trying hard to link anything and everything in his agenda to inflation.
The first two theories involved (1) higher tariffs and (2) deportations of illegal immigrants. Back in his first term, President Trump raised tariffs and reduced immigration, and CPI inflation averaged 1.9% annualized. Yes, tariffs put upward pressure on prices for the items that are tariffed But, unless the Federal Reserve starts increasing the money supply faster, that will mean countervailing downward pressure on prices for other goods and services. And what was true in 2018 remains true in 2025.
So, what about low (or even negative) immigration? Advocates for high immigration have always argued that newcomers don’t take jobs away from natives or reduce their wages because while immigrants may increase the supply of labor, they also increase the demand for goods and services. With both supply and demand rising, the impact of immigration is neutral on inflation. So, if that’s true, deportations would just reverse that, reducing both supply and demand.
Immigration surged in 2021-24 and yet inflation averaged almost 5% per year, the most in decades. If we can have high immigration and high inflation, we think the Fed can get to low inflation with low immigration, as well. So, now, with President Trump floating the idea that a portion of any savings created by DOGE could be used to pay a dividend to taxpayers…guess what…that’s inflationary, too!
Once again, we don’t think this makes sense. Inflation is still always and everywhere a monetary phenomenon, as Milton Friedman taught many decades ago. DOGE budget cuts and DOGE dividends would not affect monetary policy.
But even if we force ourselves to think within the walls of Keynesian theory, it still doesn’t make sense. If DOGE reduces government spending by $1 and policymakers then send out checks to the American public worth, say twenty cents, the deficit would still fall by eighty cents. So even if you think deficits cause inflation, DOGE would still be putting downward pressure on inflation, just not quite as much as it would if all the DOGE-related spending cuts went to deficit reduction only.
The bottom line is that regardless of whether the budget deficit is large or small, inflation still depends on the Fed. We can have a large budget deficit with low inflation, like after the 2008-09 Financial Panic and Great Depression, or a large deficit and high inflation, like during and after COVID. We can also have modest deficits and high inflation like in the 1970s or modest deficits and low inflation like in the 1950s.
It is true that a bigger government makes inflation more likely. Why? Because every dime the government spends is taken from the private sector – through borrowing or taxation. The bigger the government gets, the smaller the private sector becomes. This reduces potential economic growth. If the Fed reacts by printing more money to counteract this slower growth, or if the Fed prints money to buy government debt and finance government spending, then inflation will rise. So, DOGE, to the extent it shrinks government will actually help boost growth and lessen long term inflation problems.
Prospects for peace: At the same time, Trump is trying to end the three-year old Russia/Ukraine war. Although his methods are unconventional, he just might be able to pull it off, although nothing is assured. A mineral rights deal would strengthen the economic ties between the U.S. and Ukraine and keep the Russians from further aggression at least as long as Trump is president. Europe would benefit from a reduced geopolitical risk premium, increased supply of energy, stable prices, and the reconstruction of Ukraine. How this plays out is yet to be determined, but I get a sneaking suspicion that when funds are cut off to the waring factions, peace will become the only viable option.
We must allow some latitude when it comes to setups such as the one formed recently, especially at a time like this when prices have been whipsawing all over the place for the past three months. So, while the past few trading days were a bit of a warning that we need to watch the market’s response closely here, I don’t think it was sufficient to give up on the upside potential just yet. I could even allow for another dip down below Thursday’s low still without changing much, though obviously the further the market falls the more likely the breakout that I illustrated last week in the weekly note could then be considered a trap rather than a buy signal. Breadth wasn’t horrible these past few days either.
To conclude, the stock market so far has not seized the opportunity to take back off to the upside, yet that setup remains in place for now. It will begin to fizzle out without some follow-through higher soon, though. I’d still prefer the S&P 500 to remain above the round 6000 number, which has been a clear pivot point going back to early December. The odds for a failed setup will start to go up below there, and it will be worth treading more carefully once more just in case. It is extremely rare that investors are bearish when markets are at all-time highs. In this case since 1987, there have only been 11 instances of this and out of the 11 times, 83% of the time. Since 2009 the market has been higher 12 months out, at a median return of 15.7%. This is quite strong. The only negative occurrences were in 2007 and 2020. Since these preceded the Great Financial Crisis and the Pandemic, I don’t believe that some of the political tactics from President Trump are of the same variety, but a market is a market, and it will do what it will do!
I will continue to keep you apprised of what we are seeing in the markets. Currently, interest rates are stable, currencies are stable, and the equity markets remain in a tight range that they have been in since Mid-October. Frustrating to be sure, but still not providing clear, short-term answers.
- Ken South, Tower 68 Financial Advisors, Newport Beach
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