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.