The state of the crisis in Washington says to me "Raise more cash"

10/08/2013 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Après le deluge?

It may not seem like it this week but the current budget and debt ceiling crisis in Washington will end—and probably somewhat short of financial Armageddon.

First, of course, we’ll have to listen to endless self-serving statements from politicians all seeking to portray themselves as the saviors of all that is good. We’ll have to struggle though days when markets sell off on fears of a U.S. default and days when markets rally on a belief that even U.S. politicians wouldn’t be so insane as to risk a default that could set off a financial crisis. And we’ll go through most of this in the dark since the folks in the U.S. government who normally pump out data on things like unemployment aren’t at work right now.

But this chaos will end. And if you’ve positioned your portfolio carefully you might even wind up making a buck or two out of this uncertainty.

Deciding what that positioning should be isn’t easy. The current uncertainty is very real and while I believe the outcome will be something short of a U.S. default and a financial crisis, there’s no guarantee that the global financial system won’t go over a cliff. If we wind up in another post-Lehman bankruptcy crisis, I don't know that any positioning short of a portfolio of nothing but cash and real assets (carefully hedged to minimize currency risk, of course) will wind up offering much safety. But since the positioning that I’m going to recommend here starts with a decent hunk of cash, you’ll at least have some shelter if everything starts to go south.

Let me start by outlining what I think is the most likely outcome in this budget/debt ceiling crisis and a likely schedule.

I could be wrong and we could see the resolution of the shutdown and debt ceiling battles this week—but that’s not how I read the politics in Washington. For example, on Sunday night I read what seemed to be hopeful headlines saying that three House Republicans with Tea Party links were showing signs of changing their positions.

Changing? Well, yes. Changing in a way that moves this crisis toward a solution? No.

Republican Representatives Blake Farenthold of Texas, Doug Lamborn of Colorado, and Dennis Ross of Florida all indicated that they would back an agreement to end the government shutdown and raise the debt ceiling even if the agreement didn’t include defunding or delaying Obamacare. Of course, the agreement would have to major changes to Medicare and Social Security.

This isn’t movement toward the end of the crisis.

I don’t think the politics of the Republican Party allows for a solution to the budget impasse until the country has stepped over the October 17 deadline from Treasury. And even then, I think it’s going to take something like the inability to pay the big government obligations due on November 1 without some drastic juggling to push this crisis to a solution.

I’ve got three reasons for thinking this.

First, the pain of a government shutdown just isn’t immediate enough to change many votes in the House of Representatives. Sure, the national parks are closed and Head Start is sending kids home, but I don’t think that has enough of an impact to change votes in the House. And in the last few days we’ve even seen civilian workers at the Defense Department and workers at some defense contractors headed back to work. This kind of shutdown does seem to justify statements by conservative politicians and voters that the shut down is just not that big a deal.

Second, the Republican House leadership might be willing to—eventually—pay the political price for alienating the most conservative members of the House and the party’s political base by allowing a vote by Democrats in the House and twenty or so Republicans to end the crisis, but it isn’t likely to allow a vote on a clean continuing resolution to fund the government and then come back in two weeks to allow a clean vote on the debt ceiling. One big package to resolve both crises, yes, but only after the debt ceiling deadline has put so much pressure on Washington that politicians can’t not act any longer.

Third, not enough people in Washington or on Wall Street really believe in the Treasury’s October 17 deadline for raising the debt ceiling. The calculations on Wall Street are that Treasury really has until November 1, when there’s a big set of payments due. A significant number of politicians in Washington aren’t convinced that the cost of not raising the debt ceiling is all that great at any point. So far the very measured reaction from the U.S. financial markets isn’t putting much pressure on the financial community to press Washington for a solution or on politicians to head off the problem. To get to a solution, I think we need to see more fear on Wall Street—and in global financial markets—and lower prices for stocks and U.S. Treasuries.

So I think we’re going to have this crisis with us for a while and I think it is going to have to get worse—and particularly worse in its visible effect on the financial markets before we’ll see an end.

To me that suggests raising some cash now—if you haven’t already. The U.S. Standard & Poor’s 500 is down just 0.8% from September 18 through the October 4 close. The Treasury market hasn’t moved much either with the yield on the 10-year Treasury trading between 2.66% and 2.58% last week.  So by selling U.S. stocks or Treasuries now, you won’t be taking big losses. You will be, however, putting in some insurance if global markets get worse before they get better and giving you some cash to use in any buying opportunity that this crisis might generate before it’s done.

How much cash? 20% seems like a reasonable start with the course of the crisis determining how much more you might want to move to the sidelines.

Part of my reason for suggesting that you raise some cash now is to provide some safety against volatility. But part of my thinking involves getting ready to put money to work if the crisis pushes markets significantly lower, setting us up for a rebound when the crisis passes.

We’ve already had enough volatility to see what falls fastest when fear rises and what bounces back most quickly when fear subsides. I’d use that evidence from the last two weeks to sketch a schedule for what sectors to buy when.

For example, in the last week we’re seen big daily moves—3% or so in those emerging markets that were looking most vulnerable to a Federal Reserve decision to begin a taper. The Turkish market, for example, where investors had been worried about a drop in economic growth and a big current account deficit even before this crisis, dropped 4.5% on September 20 and then climbed 4.5% on October 1 when optimism about the U.S. crisis briefly returned to the global markets.

You’ll see similar patterns of big swings on fear and optimism in other volatile emerging markets such as Indonesia, Thailand, and India.

If you can catch one of these swings, more power to you. Just don’t hold on for too long since the fundamental problems in these markets that are causing this volatility aren’t going away with the end of the U.S. budget and debt ceiling crisis. In fact, at some point after the end of that crisis markets will again start to worry about when the Federal Reserve will begin to taper its $85 billion a month in purchases of Treasuries and mortgage-backed assets. That worry will again put these emerging markets under pressure.

It’s this lurking worry about a Fed taper and the punishment that emerging markets are likely to suffer when those fears return that led me to call Japanese stocks the best way to play the end of this crisis in my October 4 blog post http://jubakpicks.com/2013/10/04/tokyo-stocks-best-way-to-play-resolution-of-u-s-budget-and-debt-ceiling-crisis/ . With the end of the crisis, the dollar will climb and the yen—no longer the safe haven currency of choice for the crisis—will fall. That will boost Japanese stocks. The yen is likely to weaken further on any Fed taper (or Fed taper worries) and that will help Japanese stocks further.

What about other emerging markets? I expect emerging markets from China to Brazil will get a bounce from any end to the crisis. The bounce won’t be as high as for, say Turkey, but it is likely to last longer. But these markets too as susceptible to worries over the Fed taper. And frankly with the Communist Party set for its annual conference in November, I trust economic data out of China even less than usual. Yes, it is possible that the Chinese government just might paint the data to make the economy look better before the party meeting.

I’m holding my bets on European and U.S. stocks because, so far, they haven’t sold off strongly enough in the crisis to create many absolute bargains. If there isn’t any sell off, then putting money into these markets is a bet that the current crisis hasn’t hurt U.S. economic growth too badly and that the Fed will put off the beginning of any taper until sometime in 2014. For European equities the bet would be that growth will pick up in 2014 and the current simmering problems in Greece, Italy, Portugal, Spain, and France won’t grow into crises themselves.

I have my doubts on how strong growth will be in the U.S. after the crisis and how quickly European growth will pick up. And before I put money behind that potential growth I’d like to see prices fall a bit so I’m not betting on risky trends AND buying near an all-time high in the U.S. market.

Right now, therefore, I’m raising some cash and looking to see if this crisis gets scary enough to give me a reason to think I’m looking at a bargain or two. I’ll try to give you some specific suggestions for possible bargains as the crisis unfolds over the next week or so.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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