I am getting increasingly concerned that Congress will not pass an increase in the debt ceiling before it is too late and the U.S. Government will default, at least temporarily, on its obligations. To be clear, I do not think this is the most likely outcome — not by a long shot. However, the odds of it happening are no longer negligible.
If this were to happen, the results could well be disastrous. After all, T-notes are considered the safest investments in the world, at least with respect to getting your principal back and the interest payments made on time; they are always subject to interest rate risk. They are the very bedrock of the world financial system.
What This Would Mean For…Just About Everything
The U.S. government is a far more important player in the world financial system than Lehman Brothers or Bear Stearns ever dreamed of being. Heck, the U.S. government is even more important than Goldman Sachs (GS) or J.P. Morgan (JPM).
Yes, the Treasury has enough revenue coming in from tax collections to be able to service the debt, if it were to place paying interest payments at the front of the line. However, to drop overall spending to the current level of tax revenues overnight would be a massive shock to the system. Bond holders in China might get paid, but what about the soldiers fighting in Afghanistan? Would Social Security checks go out on time?
Would doctors and hospitals be reimbursed for the Medicare services they performed? Would Lockheed Martin (LMT) get paid on time for the aircraft they are making for the Pentagon? Will we have to release prisoners from Federal Prison? Will Pell grants still go out, and will new student loans be made? Will the college students depending on that funding have to drop out of school?
Worse Than the Financial Collapse
The immediate reduction in federal spending would be about $1.3 trillion. That is almost 10% of GDP. In the GDP accounting, that would cause approximately a 10% drop in real GDP. To put that into perspective, the drop in real GDP from the peak of the last business cycle in the fourth quarter of 2007, to the low point of the recession in the second quarter of 2009, was just 4.14%.
If Congress were to let the debt ceiling be hit, the drop in the stock market would likely be even worse than the decline we suffered in the second half of 2008 and into 2009. Based on strong earnings growth — and growth that has been significantly better than expected — the market has largely recovered from that drop.
I don’t think the market is particularly overvalued trading at just 13.9x expected 2010 earnings (S&P 500, bottom up expectations of $96.75) and just 12.2x 2012 expectations (bottom up estimate of $109.79). Estimates have been rising in response to the better-than-expected earnings, not just for this year but for next year as well, with about twice as many upward revisions as cuts over the last four weeks. The earnings yields of 7.19% and 8.20% — based on 2011 and 2012 earnings, respectively — are extremely attractive relative to the 10-year T-note of just 3.19%.
In other words, the underlying fundamentals of the market are still sound. However, it does not look like the market has priced in the possibility of a disaster. Make no mistake, that is exactly what a failure to raise the debt limit would be.
What I’d Recommend
I’m not in the habit of making a recommendation on which I hope to lose 100% of my investment, but this is going to be an exception. Obviously, only do this with a very small part of your portfolio. While the probability of this disaster occurring is still very low, it has probably risen to being about a 10% probability. Then again, the probability of your house burning down over the next year is probably less than 10% and you still buy insurance on it.
Using, say, 1% of your portfolio to buy deep out of the money put options expiring after all possible extension games that the Treasury can use to delay default have run out would be a good type of insurance to have. The S&P 500 ETF (SPY) is currently at 134.41.
The September 2011 put options with a strike price of 100 are trading for $0.41. If we were to have another crash due to gridlock in DC, the payoff on those options could very easily be greater than 10 to 1. Just as a warning though, the trading in the deep out of the money options, particularly away from the current contract, tends to be on the thin side.
This is a long-shot strategy. I am pretty sure that Congress will come to its senses and increase the debt limit.
GOLDMAN SACHS (GS): Free Stock Analysis Report
JPMORGAN CHASE (JPM): Free Stock Analysis Report
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