Tuesday, July 19, 2011

Debt Ceiling: Why You Shouldn't Rush to Change Your Portfolio

By Larry Swedroe

As you might expect, I’ve received lots of calls and e-mails asking what to do about the impending crisis surrounding the debt ceiling. So I thought I’d share my thoughts.

As I noted in my post on the Greek crisis, the first and most important point is that if you have a well-developed investment plan, it will have anticipated crises (which by definition aren’t predictable or we would avoid them) and incorporated the virtual certainty that they’ll occur.

In other words, we live in a world of uncertainty. As Napoleon Bonaparte stated, “Most battles are won or lost [in the preparation stage] long before the first shot is fired.” That means we shouldn’t take more risk than we have the ability, willingness or need to take. Having a plan that anticipates severe bear markets gives you the greatest chance of staying disciplined and avoiding panic selling. Without a plan, you’re much more likely to allow your stomach to make investment decisions, and stomachs don’t make for good advisors.

Returning to the debt limit problem, it certainly is true that this crisis creates the potential for another financial “meltdown,” especially when we consider that there’s a similar crisis on the other side of the Atlantic — a crisis in Greece that has the potential to rapidly spread to Ireland, Portugal, Spain and even Italy. These crises taken together — or even separately — contain the seeds for another “seizing up” of capital markets as occurred when Lehman failed.

Though my crystal ball is always cloudy, if that were to occur, it’s seems likely the valuations of all risky assets (stocks and bonds) would fall rapidly, and the more risky and less liquid the asset, the faster and steeper the fall. And since this time the crisis would encompass what U.S. investors consider the riskless asset (Treasury debt), it’s hard to even imagine what could happen. And investors hate uncertainty.

The risks are clearly great if we don’t get an agreement. The problem is that we don’t know what will happen. The crisis could be resolved, or we could see a default. We could also see defaults in Greece and other defaults might follow (or at least markets would likely worry about that happening), and we might also see the end of the Euro, and who knows what else.

I think it’s interesting to note that the stock market has risen in the past month despite these problems. On June 15, the S&P 500 Index closed at 1,265, despite:

  • The failure to resolve the US debt ceiling problem
  • No resolution on the Greek crisis
  • Weakening economic data
  • Rising unemployment
  • The end of QE2 (which some gurus were predicting would lead to major problems for the bond and stock market alike)

On July 14, the S&P 500 closed at 1,308, up more than 3 percent. And despite Moody’s warning of a downgrade of Treasury debt, the 10-year Treasury rate was unchanged at 2.98 percent. I seriously doubt anyone would have predicted that outcome. Certainly bond guru Bill Gross didn’t forecast this. He sold Treasuries back in March, and did so with a lot of fanfare. Yet just recently he started buying back Treasuries, at much higher prices.

So that brings us to what should YOU do about the situation. I can tell you what we are doing as advisors. We aren’t making any adjustments to client portfolios in response to the debt ceiling debate. The market is well aware of the fact that the debt ceiling discussions are ongoing and U.S. Treasury rates are still very low, indicating the market believes the debt ceiling will be increased and that financial market disruptions are unlikely. We believe that efforts to try to move in or out of the stock or bond markets in anticipation of what will happen aren’t productive.

Even if the worst case scenario materialized and the U.S. debt ceiling isn’t raised, it’s seems likely that it would be raised quickly if there were any subsequent disruptions in the financial markets. Also keep in mind that this is a political technicality more than anything and not an issue with the capacity of the U.S. government to pay its debts.

If you won’t follow our advice, just ask yourself what Warren Buffett is doing these days. Is he selling?

With that said, we have minimized exposure to European banks and governments. We moved money out of money market funds that had significant exposures to these credits and into what we believe are safer assets. That is a move you should consider, as it’s a classic example of Pascal’s Wager (the consequences of being wrong are really bad compared to the benefits if you’re right and no losses occur).

The bottom line is this: If your stomach is growling and you’re losing sleep worrying about the outcome, you likely either don’t have a well-developed plan or you were overconfident about your ability to deal with bad economic times. If the former is the case, then you should immediately develop a plan. If it’s the latter, you should probably rewrite your plan and permanently lower you equity allocation, because this likely won’t be the last crisis you’ll have to deal with.

Read more: http://moneywatch.bnet.com/investing/blog/wise-investing/debt-ceiling-why-you-shouldnt-rush-to-change-your-portfolio/2684/#ixzz1SZtQA1hs

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