Around the office, some of my co-workers are talking about how they just unloaded all their stock holdings and shifted into cash or bonds because of the impending Aug. 2 deadline to extend the debt limit. To do otherwise, assuming the government is unable to “prioritize” payments to bondholders (which would entail curtailing payments otherwise obligated) would constitute a default by ratings agencies (Greece just defaulted, see my thoughts on the Greek Debt Situation). The mainstream media, politicians and many economists have stated that if this were to occur, it would be akin to Financial Armgeggedon, worse than if we hadn’t bailed out financial institutions in 2008-2009.
I don’t know what the actual outcome would be if the US did default, other than some temporary chaos at a minimum and further threats of countries dropping the US Dollar as their reserve currency, but I do believe in efficient markets and I think the market has already discounted the actual outcome. The market is constantly adjusting to information in real-time and by selling off all your stock holdings now, you might end up missing out on a huge up day. Just look what happened earlier this week when it emerged that the “Gang of Six” had presented a reasonable and actionable plan to both reduce the deficit and extend the debt limit. Stocks rallied 2% that day on the news. Imagine if you had withdrawn all your holdings just prior!
Are Bonds and Cash Really Safe?
Here’s the ironic part about people shifting their holdings to bonds and cash. For one, if the US defaults, we can’t necessarily call ourselves the only “risk-free” investment anymore, right? After all, with a default, you’d think bonds would actually tank – since those interest payments will have ceased! So, some people that shifted six figures into that “safe haven” may actually take more of a haircut than stocks! Next, “cash” is usually a money market fund or equivalent in investment plans. Well, many financial experts actually predict that in the event of a US default, money markets would actually “break the buck” and funds would decline in value as well, similar to what we saw occur during the financial crisis (Financial firms actually backstopped these losses with their own funds, but that’s not guaranteed, nor are they obligated to do so).
Finally, let’s say you DID shift all your funds into bonds and cash and Congress does strike a long-term deal to extend the debt limit. This might be inflationary in nature, right? After all, all we’re doing is kicking the can down the road and chances are, some sort of interim debt limit increase will be passed, but the actual savings projected may never materialize (health care reform anyone?). So, bonds and cash will get killed by inflation while stocks will continue to happily march upward as earnings and dividend increases continue to advance, actually helped by inflation.
My advice isn’t to go buy a ton of stock or run for the hills. Whatever your asset classes correlation is in your total portfolio, if there is a default, virtually everything’s going to go haywire – and then return to normalcy eventually, as it always have. But in selling now or buying now, you may have timed it horribly.
I suggest you do nothing. Stick to your long-term investment strategy…Because the market has already discounted the risk and the outcome appropriately and to do otherwise is a pure gamble.