With only four days remaining before the United States — for the first time in its history — will default on its debt unless Congress and President Barack Obama take action, investors should be prepared for what could be the best opportunity to invest for the foreseeable future. The recent 4 percent pull-back for stocks will pale in comparison to what the stock market will do if the government defaults. Investors with available cash should have a sound strategy in place, ready to implement, should a default occur.
Optimism at the end of last week over the possibility of a compromise between Obama and the House of Representatives waned over the weekend, as Obama refused to accept the House proposal to reopen the government and to avoid surpassing the debt ceiling, as well as a proposal from Sen. Susan Collins, R-Maine, for a short-term deal. The Senate has been frantically searching for a solution palatable to both Obama and the House, with Sens. Harry Reid, D-Nev., and Mitch McConnell, R-Ky., meeting Saturday. Although this meeting was described by Reid as “very pleasant,” and McConnell stated, “We had a good meeting,” no progress was made toward an acceptable solution.
We are not two full weeks into the partial government shutdown and only four days away from a historic default. Should we default, the consequences could be dire. Stocks could easily lose 30 percent of their value, or more, and the sluggish economic recovery could be stopped in its tracks or even reversed, sending the United States into another recession.
Congress and Obama seem to be incapable of comprehending the direct link between stock market performance and the economy. The wealth effect, as it is known, is the impact that rising asset values — such and real estate and stock portfolios — have on spending habits of consumers. As personal balance sheets improve, consumers feel better about their personal financial situation, and as a result are more likely to spend. Since consumer spending represents 70 percent of the entire U.S. GDP each year, consumer spending is critical to economic growth.
The opposite is true, as well. If personal balance sheets suffer as a result of declining asset values, as happens when stock market crashes occur, consumers feel the pinch and cut back on their spending. The more severe the asset value decline, the more severe the negative impact on spending, and thus the more pronounced the negative impact on economic growth.
The silver lining in the black storm clouds looming over us, with the threat of a U.S. default, is the possible investment opportunity that will result if the stock market corrects or crashes. For those who have cash available to invest, this will very likely be the last, best opportunity to put that cash to work at very attractive valuations for stocks. A 30 percent correction would bring the Standard & Poor's 500 down to approximately 1,200, or by about 500 points. A drop of this magnitude would basically bring the market back down to where it was in November 2012, when the current stock market rally began. While I hope this does not happen to the market and the economy, a drop of this magnitude would represent a compelling buying opportunity.
As we move closer to Oct. 17, the day that the Treasury Department estimates we will run up against the debt ceiling, if a solution has not been reached the stock market will become increasingly jittery. The market could pull back by a significant amount leading up to Oct. 17, even if a compromise is reached just before that deadline, offering a smaller, but still significant opportunity to invest cash. If we do not find a compromise, I feel certain that we'll see a very substantial sell-off in stocks.
Investors will not only want to be prepared to take action, they will want to have a well-reasoned investment strategy in place, with detailed targets for investing in key sectors, industries and individual stocks. I employ a sector rotation strategy, which simply means that I focus on specific sectors of the economy, based on my expectations for how each sector will perform over the coming economic cycle.
Since I believe that the recovery will continue and will build in strength over time, I'm focusing on those sectors that tend to perform best in a recovering economy — the higher growth sectors, which include technology, industrials and consumer discretionary. In addition, I will look at energy, although there are other factors that affect the performance of this sector that must be considered. Within these sectors, I select those companies that I believe represent the best fundamental strengths, and therefore the best opportunity for positive performance. By choosing high-quality companies in the most attractive sectors, investors should garner the best chance for strong overall portfolio performance moving forward.
This week will be interesting and challenging. Stocks will no doubt experience a tremendous amount of volatility — if a compromise is reached, we should see some additional upside, building on the gains from the end of last week. If a solution is not found and we default, stocks should correct dramatically, and savvy investors should be prepared to take action.