What investors need to know about the debt ceiling debate

Forecasting big events is a special problem. It is not enough to look at the average outcome.  In bi-polar cases either result could have a major market effect.

Such is the case with the debt ceiling controversy.  It will either be increased — or not.  The bond market does not reflect the possibility of a default, but the stock market probably does.

The issue is so important that it is attracting time on mainstream news, not just in the financial media. In this article I want to illustrate the significance of the issue, highlight some other predictions, make my own forecast with supporting evidence, and contemplate the investment consequences.

But first —

What this article is NOT about.

Many of those commenting are interested in the nature of the compromise that might result, and offer opinions on that front.  In general, I refrain from commenting about what policies should be, preferring to discuss the investment consequences of what I expect to happen.  Today I am going to make an exception.

As someone who has supported and voted for leaders from both parties, and as someone who is a strong advocate of free markets, capitalism, and entrepreneurial activity, I do have an opinion.

Using the creditworthiness of the US as a bargaining tool is wrong.  I expect that my own (Republican) Congressperson, whom I have helped to elect, will use her ability to reason and see that this is not the best method for changing policy about taxing and spending.  I do not expect her to play poker — going "all in" on a reckless gamble with the US credit rating.  Her constituents have too much at stake, and I trust that she will realize that fact.

My guess about her behavior does influence my expectations on the outcome.

The Issue Significance

This subject is getting major play on regular news and non-stop coverage on CNBC.  I know from my blog comments and email that it is a source of concern for many average investors.  A recent CNBC poll showed that 1/3 of those investors with an opinion expected the US to default!  One of the online polls today said that 56% of investors are changing their investment posture because of this.  ( I usually ignore these polls since the sample is not representative of the general public.  For this particular purpose, it probably reflects investors who are engaged and watching CNBC).

This general conclusion is confirmed by reports of outflows from equity funds and increased investor skepticism.

Other Predictions – Mostly Wrong

From my perspective, most of the predictions are fancy, but pretty lame.  Here is an example from Jeff Kleintop — a good source — writing at TheStreet.com.  He has a nice chart showing a decision tree of the outcomes.  Read the whole article to get the perspective.  (Barry Ritholtz highlighted a similar chart from SocGen.  I don't know who had the idea first, and SocGen's forecasts are equally mistaken).

Kleintop debt ceiling tree

This is a very nice presentation, but the percentages do not get much justification in the article.

Let us take a deeper look.

My Own Forecast

Here is my general assessment, written to an astute colleague who was frustrated by the political posturing:

You are too much concerned about the irresponsibility of the participants and your political viewpoint, and too little concerned with what students of political behavior would predict:  posturing, delay, self-aggrandizement, bargaining behind the scenes, credit-claiming, etc.  Meanwhile, the bond market will lose more than $100 billion if there is a default, to say nothing about stocks.  Social Security payments will be halted.  Voters will blame both parties, therefore they will cooperate to avoid this outcome, while claiming to have extracted the last pound of flesh.

Let me be more specific about this overview.

Beginning with the mid-July resolution,  I place this probability at near zero, not 25%.  There is no imperative for an early resolution, and plenty of incentive to play this for maximum effect.  The official deadline is July 22nd, and there might even be a little slippage in that. 

As to the size of the increase, I see little chance that Obama will accept something that brings the issue up again before the 2012 elections.  It is both foolish and unnecessary.

There will be an eleventh-hour vote that provides a credit-claiming and face-saving outcome.

Here is the evidence on the bond market effect.

Here is the story on social security.  And yes, I know that Republicans allege that this could be avoided, but that is not the point .

Both parties will be blamed — nearly every poll agrees on this subject.

Business leaders are talking to Republicans.  And everyone knows this.  Wall Street pros are taking this in stride.  The average investor is the victim.

A resolution will be achieved because this issue lends itself to compromise.  Small concessions can and will be made until a minimal winning coalition is achieved in both houses of Congress.

The result will have some ambiguous language about tax cuts and entitlements, something that both sides can claim as a victory.  For an example, read the wisdom of Bob McTeer:

While I agree with those who argue that we need less government spending rather than higher tax rates, their game of chicken over the debt ceiling makes me very nervous. I’m afraid the other side will win by doing nothing, even though win is not the right word. What we need is something I’ll call “constructive ambiguity,” or language that will enable both sides to save some face.

McTeer is a conservative Republican with strong ideals.  He is also a pragmatist with plenty of experience.  His opinions deserve more attention.

Investment Conclusion

Please note that my forecast is much more specific than the other sources. 

How you trade the debt ceiling debate depends upon your time frame.  If you agree with me that this will play out over the next two weeks, there might be a better buying opportunity.

Having said this, most investors (and many managers) have trouble chasing stocks after a big rebound.  My own approach with recent new accounts has been to establish partial positions.  There may be a further decline, but it is better to get started than to be caught completely flat-footed.  I continue to believe that this is a good time to invest for those with a time horizon of a year or more.

How agile are you?

 

 

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8 comments

  • Paul Nunes July 6, 2011  

    jeff; i hope all your readers appreciate your efforts in this area. great work!

  • James Williams July 7, 2011  

    “I expect that my own (Republican) Congressperson, whom I have helped to elect, will use her ability to reason and see that this is not the best method for changing policy about taxing and spending. I do not expect her to play poker — going “all in” on a reckless gamble with the US credit rating. Her constituents have too much at stake, and I trust that she will realize that fact.”
    You’ve told us you expect your Rep to be reasonable — have you told her? Let your electeds know how you feel about this issue.

  • oldprof July 7, 2011  

    James — absolutely right. We should always take the time to write, especially on important issues.
    In my case, I also sent her a link to the article.
    Thanks,
    Jeff

  • Bill July 9, 2011  

    Hi Jeff,
    I have not been regularly following your blog, lately, and so you may have already stated the numbers. But,
    what percent are you invested in bonds and equities? If there is a default what kind of correction do you think that there is going to be in the global mkt?
    Personally, I remain fully invested. I accept that there may be short term pain but I agree with you that a rebound is going to be rapid. Timing when to get back seems too hard given that 80% of all trading is computer driven. I am willing to risk that the regular investor has strong hands. I am the guy in the street who just assumes that our politicians are coaxed by other politicians to be drama queens. Volatility will be noise and not a trend correction. Having said that, I am not sleeping all that well. What helps is the further assumption that the fundamentals are still regarded as better than equity prices…ergo, stocks are under-valued.

  • mybestfunds.com July 10, 2011  

    Excellent post and comments. I’ll be sending this along to my congressmen also. Keep up the great work!

  • oldprof July 10, 2011  

    Bill — Each client has a different asset allocation based upon individual needs. I have some warning indicators to help timing for long-term investors. None of these are flashing a warning right now. It is something that I track every day, and report some of it in my weekly column.
    You are certainly right about the difficulty of market timing.
    Thanks,
    Jeff

  • oldprof July 10, 2011  

    Thanks. We need reason.

  • oldprof July 10, 2011  

    Thanks, Paul.
    I know you share my concern for the average investor.
    Jeff