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Rotblut: The Debt Ceiling and Your Portfolio

Judging by this week’s auctions, the bond markets aren’t too farklemt about the August 2 deadline for raising the debt ceiling. Tuesday’s auction for two-year notes went fairly well and Wednesday’s five-year note and today’s seven-year note auctions drew decent demand. This suggests that bond buyers expect a resolution to be reached.

Politicians should not view such results as an excuse to let themselves off of the hook. Presuming a resolution is not reached by the time you read this, the auctions also don’t mean that we’ll able to avoid seeing those debt ceiling countdown clocks that the news channels are airing. The auctions certainly don’t suggest that frustrated voters can stop being frustrated.

What the auctions do suggest is that the financial markets anticipate that the Treasury Department will pay its bills. It is uncertain which bills will be paid on the days following August 2 and which will be postponed, but the financial markets do not expect Uncle Sam to become a deadbeat. For owners of Treasury bonds, U.S. savings bonds and other U.S-backed debt, this week’s auctions show a belief that you won’t be left holding the bag.

This is not to say that there won’t be an adverse impact on the financial markets if the crisis drags on. The whims of politicians even manage to befuddle Washington experts. Financial analysts’ models predict future cash flows, not Congressional votes. Should the August 2 deadline arrive with more posturing than compromise, we all might be reaching for aspirin and Rolaids. My crystal ball is not good enough to predict when the current stalemate will end, but it seems likely that a resolution will be reached. The problem with trying to time a trade based on the crisis is that we don’t know when it will end or whether there will be a sizable relief rally in response.

It is important to realize that in the backdrop of the debt talks, the pace of the economic expansion has slowed. (This morning’s estimate of second-quarter GDP was well below the consensus estimate. Furthermore, the rate of first-quarter growth was cut significantly.) Thus, Wall Street’s focus will be on the economy, not the eventual debt ceiling resolution, in the weeks to come. Furthermore, in the one- and three-month periods following a raise in the debt ceiling since 1969, the median increase in the S&P 500has been 0.6% and 0.9%, according to Sam Stovall, chief investment strategist at Standard & Poor’s. This compares to a median monthly gain of 0.9% and a median three-month gain of 2.2% for all months since 1969. Furthermore, August and September rank among the worst two months for the major stock market indexes according to The Stock Trader’s Almanac. Just keep in mind that the future is rarely what we expect it to be.

What we do know is that any resolution is likely to include budget cuts. If you are invested in companies that depend on government spending, you should gauge the impact that such cuts will have on future revenues and earnings. If you find it difficult to ascertain the impact, monitor earnings estimates for this year and next. Brokerage analysts should adjust their earnings downward if the company will be adversely affected.

Watch Out for Scams

Con men use crises, such as the debt ceiling situation, to scam people. They will use scare tactics to separate you from your money. Due Diligence: 10 Steps to Avoiding Ponzi Schemes and Financial Fraud gives easy-to-follow guidelines to keep you from becoming a victim.

If you are approached with an investment strategy relating to the debt ceiling, ask the adviser if you can call him back in a few weeks. A reputable adviser will not pressure you to act now and will give you all of the necessary information—including full contact information; a criminal looking to make a quick buck won’t.

What Happens on August 2?

On Tuesday, August 2, if a resolution to the debt ceiling issue is not reached, the reaction in the U.S. financial markets will likely depend on how close traders think Congress and the White House are to a resolution.

The Treasury Department will have to prioritize payments. Social Security checks are scheduled to be sent on August 3, and this will be one benchmark that many people will be watching. A likely outcome if a debt ceiling resolution is not reached would be some type of government shutdown. This could impact the Securities and Exchange Commission, halting mergers, stock and bond offerings, the launch of new ETFs and other actions that require regulatory approval.

I have seen news reports that say that money market funds have taken measures to protect themselves over the short term. If you have concerns, I would contact a representative of the fund you are invested in.

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Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors (http://www.aaii.com) and editor of the AAII Journal.