Investing Before a U.S. Default

Stock investing has one tremendous advantage that long term investors bank on but which short term investors loose sight of all too quickly: equity markets have an upward bias over time.

Yet with U.S. stocks climbing higher and higher – without a sizable correction for two full years since the 18% rout in the late summer of 2011 – experts are cautioning investors to trim profits, get defensive, and keep some cash on hand. They see the current gridlock in Congress as the trigger for a severe market correction.

How should investors position themselves to best navigate these near term uncertainties, while still remaining eligible for the market’s long term upward bias?

Near Term Danger

Since the middle of last month, as investors started to worry over the then-approaching government shutdown, the S&P 500 index dropped some 3.1% – before the event even took place.

It is reasonable to expect, then, that as the U.S. government gets closer and closer to maxing out it credit limit on October 17^th, there could be another leg down in equity markets in anticipation of a default. “The next two weeks could cause a lot of pain in many portfolios,” Mark Yusko, CEO and chief investment officer at Morgan Creek Capital Management, cautioned to Reuters.

The threat is very real, as President Obama staunchly emphasized: “There will be no negotiations over this.”

The Republicans are trying, though. “The [Republican House] speaker has been trying to unify us for a long time,” Representative Devin Nunes, a California Republican and Boehner ally, informed Bloomberg. “The problem is it’s impossible as long as we have people out telling their constituents that there is a magical way to get 67 senators and 290 House members to override a presidential veto.”

So while the Republican leadership may be considering ways to get the government reopened and increase the credit limit before the 17^th, many hard-liners in the House of Representatives are encouraging their camp to keep holding out, using the threat of default as leverage to at least gain some tax breaks in the negotiations.

If no agreement is reached by the 17^th, the impact could be severe. “What it does is that it slowly undermines the status of the U.S. dollar,” Andrew Milligan, head of global strategy at Standard Life Investments, underscores to Reuters. “If there was a period of time, even a day, when someone can’t transact what he wanted to transact, that memory will last a long time.”

Given the status of the USD as the global reserve currency, a hit to its money would raise “a very real concern about the U.S. and its weakening position in the world,” Dan Fuss, vice chairman of Loomis Sayles, stressed to Reuters.

Protecting Against a Default

Since a default would put downward pressure on the USD, some analysts are recommending foreign bonds and currencies, highlighting the stronger economies of Germany, the UK, Switzerland, and even Japan. For a slightly riskier trade offering greater upside potential, Societe Generale analyst Eamon Aghdasi recommends the Brazilian real, Mexican peso, or even Chile’s swaps rates.

Others suggest taking advantage of increased volatility with long call options on the CBOE Volatility Index (VIX) or long put options on the S&P 500 or other major indices. “Even a legitimate threat of a default will send volatility exploding – even to the 30s,” Yusko anticipates to Reuters. “You can make a lot of money in a short period of time.”

Douglas Peebles, chief investment officer for fixed income at Alliance Bernstein, agreed. “Don’t short volatility,” he advised to Reuters. “Because all roads lead to it. There is going to be less liquidity and more question marks about gridlock and growth. That’s painful to sit through, but it’s fertile ground” for increasing returns.

But will a default even happen? Societe General considers it highly improbable, while money managers Laurance Fink of BlackRock Inc. and Bill Gross of Pacific Investment Management Co. speaking at UCLA’s Anderson School of Management last week dismissed the likelihood altogether.

Diving into foreign currencies and bonds or expensive volatility options seems like quite the gamble for an event that will likely not happen at all.

Investing for the Long Term Bias

Downplaying the expected catastrophe of failing to raise the debt ceiling by October 17^th, Andrew Milligan, head of global strategy at Standard Life Investments, clarifies to Reuters:

“Missing a single payment or a series of social security payments is incredibly damaging, of course, but that’s still very different from Argentina informing the world, as it did a few years ago, that it’s defaulting on its debt.”

Even famed equities investor Warren Buffett sees the drama as much ado about nothing, expressing in an interview on CNBC last week, “If it goes one second beyond the debt limit, that will not do us in. If it goes a year beyond that would be unbelievable.” Former chairman and CEO of Goldman Sachs, Hank Paulson, added during the same interview, “These guys [politicians] may threaten to take their mother hostage, but they will never hurt their mother.”

So what is the more sensible way to position oneself for the possibility of a default, while still keeping in mind the markets’ long term bias to climb ever higher once the danger has passed?

Some analysts, including Fuss, recommend longer-dated U.S. Treasuries, which rallied after Standard and Poor’s downgraded the U.S. credit rating in August of 2011. Why would Treasuries hold up well this time too? Because the threat of default leading up to October 17^th and any default afterward would slam the USD down, making longer term bonds more valuable for their higher interest yields locked for a longer time.

But perhaps the most effective means for the ordinary investor to take advantage of temporarily cheaper markets over the next couple of weeks is to buy on the dips. Dan Yu, managing director of Eisner Amper Wealth Advisors LLC, is recommending keeping some cash on hand for just such a plan. “We’re cash-heavy,” he informed Reuters, “but I might be a buyer if we see a 5 percent pullback in the stock market”.

As painful as the past major corrections have been – the tech crisis of 2001-03, the financial crisis of 2008-09, and the credit ceiling crisis with its simultaneous credit rating downgrade of 2011 – any graph you look at will tell you that those plunges afforded investors tremendous buying opportunities. From trough to subsequent peak, purchases made in the thick of those storms returned 95%, 100%, and 63% respectively on the S&P 500. That represents three powerful bull runs in one ten-year period.

The risk of default does exist, warranting a defensive posture. Reduce your margin exposure, increase your cash balance, and space your purchases out every two or three percentage points down or so.

But the likelihood of default is slim. Remember that the market’s long term upward bias makes any short term correction something to embrace, not fear.

Joseph Cafariello

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