Bumping Heads on the Debt Ceiling? - Analyst Blog
05 Luglio 2011 - 1:32PM
Zacks
The fundamental backing for the market continues to be solid. It is
important to keep your eyes on the prize.
There is lots of news out there, and much of it is more dramatic
than earnings results, but rarely does it have more significance
for your portfolio. Earning are -- and are going to remain -- the
single-most-important thing for the stock market. Interest rates
are an important, but distant second.
We certainly had an impressive week in the market last week, with
the S&P climbing by almost 60 points or 4.67%. The rise through
Thursday was just about enough to offset the losses earlier in the
quarter and bring the second quarter to a nearly flat close.
Greek Drama to Continue
The gains on Friday got the third quarter off to a strong start.
The primary reason for the rally is that the Greek debt can was
successfully kicked down to road. This is not the end of the Greek
drama by any means. Soon enough they are going to find that the
road is a cul-de-sac. The austerity programs that were imposed on
the Greek economy as the cost of getting the loans are shrinking
its economy.
It is extremely unlikely that Greece will ever be able to pay the
money back, and the debt will be restructured (aka partial
default). So is the whole exercise pointless? Perhaps not, if the
European banks use the time to build up their capital so when
Greece does default, they will not go under as well. Either Greece
will be a perpetual charity case, propped up by mostly Germany, or
it will leave the Euro and go back to a very much devalued Drachma.
Unscrambling that egg will not be easy or painless.
The Debt Ceiling
The big remaining worry is the debt ceiling fight on this side of
the Atlantic. The difference between Greece and the U.S. is that
Greece is unable to pay its debts. The U.S., if the debt ceiling is
not raised, will simply be unwilling to do so. That would be
entirely an unforced error.
The Government of the United States defaulting on its debt would
likely have a much larger impact on the markets and the economy
than the impact of Lehman Brothers defaulting on its debts. The
nation would be shoved right back into recession, and one deeper
than the one that followed the Lehman collapse. If that happens,
then corporate profits would also collapse.
However, when push comes to shove, I find it hard to believe that
even Congress could let that happen. While not the most likely
case, the chance of no increase by the time the ceiling is hit is a
very real possibility.
Over the long term we need to close the budget gap, but we need a
balanced approach to it. In theory, both tax increases and spending
cuts tend to slow an economy, but by how much varies a great deal
depending on the nature of the tax increases and the nature of the
spending cuts. Cutting tax subsidies for, say, ethanol is likely to
be far less damaging than, say, cutting spending on
infrastructure.
The most recent plan being discussed is a package of 87% spending
cuts and 13% revenue increases, almost all of the revenue increases
are from cutting spending that is embedded in the tax code, and
which mostly benefits the wealthy. I think that is way out of
balance already.
There is a good argument that what Obama should do is simply ignore
the debt ceiling and issue debt anyway. There are substantial
grounds that the debt ceiling is unconstitutional in Section Four
to the 14th Amendment, but an equally strong argument based on
Article One, Section Eight that doing so would have the Executive
branch stepping on the Legislative branch’s turf. It could provoke
a Constitutional crisis.
In the end, I find it almost impossible to imagine the debt ceiling
not being either raised or ignored. The most likely scenario, and
the one that the markets are clearly betting on, is that there will
be a last-minute settlement.
...But What If...?
The chance of this game of chicken having a tragic ending is no
longer trivial. That tragic ending would result in a huge market
crash.
Taking out some insurance would make a lot of sense in here. My
preferred way of doing so would be to buy some out of the money
September puts. On the the
S&P 500 ETF (SPY)
the September 120 puts are only trading for $0.89. Obviously I hope
that they would expire worthless, just as I hope that my life
insurance policy does not pay off anytime soon. Still, it is
insurance that would be well worth having.
On balance I remain bullish, and I think we will end the year with
the S&P 500 north of 1400, but that does not mean we will have
a smooth ride between here and there. Strong earnings should trump
a dicey international situation and the drama in DC (provided it
turns out to be just drama, and the game of chicken does not end in
tragedy).
Valuations on stocks look very compelling, with the S&P trading
from just 13.55x 2011, and 11.93x 2012 earnings. That is extremely
competitive with the 3.18% yield on the 10-year Treasury
note. However, be prepared to move to the exits
(or have some put protection in place) if it looks like the debt
ceiling will not be raised.
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