With all of the talk about the Armageddon that will ensue if the US debt ceiling isn’t raised, one might think that stocks are the last place one would want to be. If that were the case, however, one would expect to be seeing a massive sell-off in equities already even though we are a few weeks away from a possible debt ceiling impact. The reason is that the stock market is forward-looking. Individuals try to predict future earnings for companies, along with the risk associated in getting that return. They then will not buy shares until the price is low enough such that the potential return, in share price appreciation and dividends paid, is high enough to justify the risk taken.
While there have been minor sell-offs during the last few days, there is certainly no indications that the market is expecting the end of the world. Individuals are still more concerned about return on their investments than the return of their investments. This was not true as the housing bubble was unfolding in 2008 and the prices of even quality companies were falling by 80% or more.
In reading articles like that in the Huffington Post, one would have expected the market to have already fallen by 20% or more, just in case a deal is not reached by August second. After all, the article talks about everyone “taking a big hit.” Of “your 401k and/or pension will suffer big losses.” Of “delaying retirement – or making it impossible.” Who would want to hold onto stocks with that sitting over one’s head.
The reason for the lack of a significant slide is probably a combination of factors. The first is that there is an expectation that a last-minute deal will be made to raise the debt ceiling. There has already been talk of a series of small increases to buy time. The second is that not increasing the debt ceiling would not necessarily lead to a default, given that the amount of money needed to pay the interest on the current US debt is only about 10% of current revenues, meaning that the government would not default on the debt unless the decision was purposely made to put the debt behind other activities.
While a default is not likely, it is true that the government cannot keep spending like it has been without an increase in its credit line. This is more like a family reaching the limits on its credit cards, however, and needing to eat more meals at home, rather than like a family losing all income and becoming unable to make the mortgage payment. There are a few areas that would suffer, however, since these areas depend directly on the government for much of its revenues. One would therefore be wise to avoid these sectors, at least until the smoke clears. These are:
Defense stocks: Obviously, most of the revenue for defense contractors comes from Federal Government contracts. Should the Government need to trim back, the number of new contracts would decline and it might be necessary to delay the continued funding of existing contracts.
Aerospace Companies: Many of these are primarily defense contractors, deriving a lot of their revenues from military planes and missiles. Perhaps one of the exceptions is Gulf Stream which makes money from commercial sales of business jets, but then again the White House has business jets squarely in its sights. They are looking to take away a tax depreciation method that was put in place by the Stimulus Bill, now calling it a give-away for millionaires and billionaires.
Washington DC Real Estate: The beltway is packed with various lobbyist groups and defense contractors wanting to be close to Congressmen. If the Government reduces spending, there will be less money to go around, possibly resulting in a decline in office space rentals and a decline in Washington DC real estate prices and REITs.
Restaurants and Hotels: Like the housing bubble, the Washington spending bubble has resulted in phantom spending. The government has been injecting money into the economy for which no value has been created by borrowing from the future. This means that there is current spending that exceeds the actual amount of wealth in existence. When the housing bust came, people could no longer borrow from their homes and spend money they did not have, thereby supporting discretionary spending and a whole industry that depended on this phantom spending. While the effect from a cut in Government spending would not be as great as that seen in 2008, since the amount of borrowing isn’t as great, there would be some drop in spendign and a contraction. This would result in lost revenues on things people can go without.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.