Profiting from Debt Woes

07/15/2010 11:17 am EST


Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of Short-Side Trader, says the debt problems of states and cities—as well as nations—won’t improve soon, and he recommends a short play.

Almost all countries facing sovereign debt concerns, led by the UK and Ireland (and including the US) will continue to run deficits, but they won't increase the deficits and will most probably try to shrink them over time.

Falling bond ratings, US elections, UK government constraining actions, and a German constitutional mandate that forces the government to sharply reduce its deficit as a percentage of [gross domestic product] by 2016, will drive this process.

No one is willing to force banks to shore up capital or clean up their balance sheets at this point. A new set of standards called Basel III will be approved that will allow banks to grow their core capital and reduce their bad assets slowly. But implementation will be pushed back for several years as the world's leaders continue to try to buy time.

Another thing not said, but thought, at the G20 conference is that a worldwide recession—called a slowdown by the G20 and many others—is clearly on the way.

The bottom line is that longer-term headwinds against our positions from the "economic recovery trade" are now becoming modest tailwinds for us. These tailwinds will strengthen as the governments of the world do little and the economic contraction continues to play itself out.

Citizens know that even without new stimulus, runaway entitlement programs have created massive structural deficits north of 70% of GDP, and political support for austerity over stimulus should only increase in time.

Forty-nine states are required by their constitutions to have balanced budgets, and 44 of them need to have those budgets in place [soon]. Projected deficits for this and the next fiscal year are in the [hundreds] of billions [of dollars]—and Washington is no longer sending stimulus money their way.

Declining revenues and out-of-control pension and health care expenses are crippling states, and a civil war between public sector unions and their employers—aka, the people they voted into office—has begun.

What do all these government problems mean for us?

Two things:

First, at a macro level, fiscal austerity—including eliminated and smaller spending programs, reduced transfer payments, and reduced or no hiring—will bring down consumer income, consumer confidence, and consumer spending.

Second, specific companies are apt to be hit, [like] McGraw-Hill (NYSE: MHP), because of expected softness in textbook sales and reduced revenues for Standard & Poor's, a ratings agency owned by MHP.

Bond issuance has softened considerably since the beginning of the European debt crisis and I'll be adding more of this type of trade to our portfolio list in the future.

So, [buy] McGraw-Hill Nov 25.00 Puts (MHP 101120P00025000)Buy under $1.45. (They traded at around 80 cents Wednesday, while MHP shares closed above $30. Short selling is only for extremely risk-tolerant investors who can afford to lose the money they’re putting in to these trades—Editor.)

Subscribe to Short-Side Trader here…

  By clicking submit, you agree to our privacy policy & terms of service.

Related Articles on STOCKS