Debt Default-The March Of Folly
Investors today are battered with headline news of breaking events. The natural response is to react to these bulletins by buying or selling something, a reaction that is quite often completely wrong. One of the hundreds of old Wall Street sayings is “Don’t sell on news of a strike.” This was coined in the days when both labor unions and automakers were major forces in our economy.
In those days, a strike by the United Auto Workers against General Motors, for example, would have severely impacted the entire economy. Such high stakes meant that it would have happened only after several months of negotiations and its impact would have been assessed and already reflected in the stock prices of GM and its suppliers. Investors were sometimes puzzled when news of a strike and the removal of this pending uncertainty actually caused a move up in their stock prices.
The dominant present uncertainty is the unsettled debt ceiling legislation. This obsolete law originated with Liberty Bond sales to finance U.S. participation in World War I and was originally intended to give the Treasury flexibility to issue additional bonds without having to go back to Congress. It became a subject of partisan debate through the years although never so much as now.
Despite its use primarily as a debating tool, Congress has managed to raise or extend it 78 times since 1960. Wall Street has assumed that it will probably do so again and failure to do could trigger a nasty sell-off. The immediate consequences would be higher interest rates at the next Treasury bond auction and brakes being applied to the fragile economic recovery. The longer term consequences were noted a generation ago, when President Reagan, urging Congress to increase the debt limit, wrote, “The full consequences of a default-or even the serious prospect of default-by the United States are impossible to predict and awesome to contemplate.”
Short-term, a recent precedent is the 775-point drop in the Dow in 2008 after the initial failure by Congress to approve the TARP plan to bail out the banks. The politicians quickly adjusted to this market reaction and bailed out the banks while investors absorbed this news and went on to anticipate the next crisis.
The trick is to assess and anticipate probable events rather than to react to what has already happened. This default, even if avoided by a last ditch maneuver, will require the Treasury to pay higher rates to continue the necessary financing of running the world’s largest government. Winding down two wars will reduce expenditures. Economic recovery, if not derailed, will bring greater tax revenues but interest rates will probably be kicked up somewhat before their time.
Fortunately, world finance is highly competitive. European bonds are also suffering from self-inflicted wounds, thus Treasuries should not suffer excessively after this needless march of folly. The inevitable retreat from today’s record low interest rates will be accelerated, thus rate risks of long-term bonds are now more acute.
Most stocks today are buoyed by favorable earnings reports and moderate valuations. A short-term stock market break is likely should the Treasury slide into a blatant default on its obligations, as this would trigger massive unwinding of staggering sums of intricate credit default swaps among the world’s banks. Such a default would not directly affect the operations of a debtless company like Apple (AAPL-$392) but leveraged swap holders might be forced to sell stocks in great companies in order to meet margin requirements.
Readers probably have not been overleveraging themselves with such gambles but I regret that resolution of this uncertainty may take longer than it appeared only a few days ago. Stocks have already slipped over 400 points on the Dow Industrials as the news became increasingly negative. An increase or even an extension would ease prevailing fears, probably triggering a substantial rally. Pending some sort of resolution, patience is appropriate.
I am confident a good buying opportunity for stocks lies ahead, less confident as to its timing. Shopping lists should feature global companies with strong balance sheets and rising earnings. Three of my picks are based in Switzerland, a plus factor when other economies wobble. These are Novartis (NVS-$61), Syngenta (SYT-$63) and Weatherford (WFT-$22), in health care, agriculture and oil services.
The stock market always discounts uncertainties, providing opportunities for those ready. Today’s political snarl is unusual but investors may find comfort in Winston Churchill’s words, “You can always count on Americans to do the right thing-after they’ve tried everything else.”
Tony Crowell manages stock portfolios for individuals and their trust and retirement accounts with CROWELL•ROBERTS Investment Counsel, a registered investment advisor in Laguna Beach since 1993. [email protected] 949.494.1376/