October could be a tricky month–but for unusual reasons

October selling

Seasonal weakness usually hits the US equity market in late September and continues through the first half of October.  The reason is tax selling by mutual funds and, to a much lesser degree, ETFs.

mutual fund/ETF tax planning

A mutual fund or an ETF is a special kind of  corporation that is exempt from income tax on any profits it makes, provided that it sticks to portfolio investing and distributes to shareholders basically all realized gains.  These payouts become taxable income to their recipients.

For every mutual fund or ETF I know, the fiscal year ends on Halloween.  That’s when the fund has to figure out its gains and make the required distributions.  This has nothing to do with trick or treating.  It’s October so the fund can close its books and send out the distributions before December.

Funds typically begin to prepare for their yearend in late September.  They either sell winners so they can make a distribution (for some reason, shareholders regard distributions as a good thing), or they sell losers, to use the tax losses this creates and to keep the distribution down to a reasonable size.

Not this year, though.  In fact, not since 2009.  As far as I can see, most mutual funds/ETFs still have considerable accumulated tax losses on their balance sheets.  Those resulted from the massive panic-induced redemptions that occurred at or near the bottom of the market in early 2009.  The losses, which offset realized gains, will swamp any profits funds may have made this year.  So there’s no point to doing normal year-end tax selling until past years’ accumulated losses are either used up or expire.

this year’s issue is different

It’s budget negotiations in Congress.

spending power

One negotiation, whose deadline for action is tonight, is over Congress giving the administration authorization to spend money to run the Federal government.  Talks are deadlocked.  Absent a last-minute compromise, an estimated 800,000-1,000,000 government workers will be furloughed effective tomorrow.  That’s out of 2.1 million Federal employees.

The furloughs would add about .6% to unemployment in the US.  They would also have negative economic ripple effects, as corporations that do business with Washington defer spending plans while they wait for the situation to develop.

According to USA Todaythe Federal government has shut down 17 times since 1977, though usually only for very short periods of time.

borrowing power

The second, and more important, negotiation is on raising the Federal debt ceiling.

Washington currently borrows about 20¢ of every dollar it spends.  The Treasury estimates it will reach the limit of its current borrowing authority from Congress in mid-October.  Without an increase, the government will be reduced to spending only money that comes in the door from taxes and other payments.

At some point, it’s possible that the Treasury wouldn’t have enough money on hand to make interest payments on the Federal debt or redeem Treasury securities that come due–meaning the US would be forced to default on its debt.  That would be awful.

Wall Street worries

I don’t think Wall Street–and any other world stock market–will find it easy to move up during a period of uncertainty like this one.

The main issue, of course, isn’t the looming government shutdown.  The longest happened during the Clinton administration–twice.  The S&P fell modestly, and quickly regained lost ground after the shutdowns ended.

It’s the question of whether the crazy behavior of Congress in causing the shutdown will be repeated in the debt ceiling talks, where the stakes are much higher.

Personally, I can’t decide whether the Tea Party Republicans who are at the core of the disputes are content to bring the government to edge of disaster before compromising, or whether they want to go further.  After all, in March 2009, a group of similar-minded Republicans voted against the bank bailout, saying they would prefer a repeat of the Great Depression of the 1930s to pumping money into bankrupt financial institutions.  The S&P fell by 7% on that news.  Then the Republicans changed their minds.

That was a great buying opportunity for stocks.  Hopefully, we won’t have another one.  But uncertainty will likely keep a lid on the market until the debt ceiling issue is settled.

what I’m doing

From a strategic point of view, I think the best course is to believe that politics will eventually work itself out and to not change portfolio positioning.

My tactical view is a little different.

In times like this, short-term traders tend to argue that if the market can’t go up, there’s only one direction it can move in.  So the lack of upward potential implies downside pressure.

That make me a buyer on weakness.

downgrade, default and Default: a Washington scorecard

framing the issue

1.  In round terms, the Federal government is taking in $2.5 trillion a year and spending $4 trillion.  It borrows the $1.5 trillion difference by issuing Treasury securities.

The main areas of government outlay are:

–military     25%

–healthcare     23%

–pensions     21%

–welfare payments     13%.

Interest payments on Treasuries amount to around $200 billion.  That’s 5% of total outlays, or 8% of tax receipts.  This isn’t a near-term concern, but imagine what would happen if fates started to rise.

2.  Congress periodically passes laws setting a maximum allowable level of federal government borrowing.  The current limit is $14.3 trillion (including things like government agency debt in addition to Treasuries).  The Treasury Department estimates Washington hit that limit in mid-May.  The Treasury can create wiggle room for a while–like keeping the proceeds of maturing Treasuries in federal government employee retirement funds under the mattress instead of reinvesting them.  Such stalling tactics will probably run out within a couple of weeks.

what can happen

rating agencies

Let’s look at the rating agencies first. 

S&P is saying that it wants to see some evidence that Washington will do something now to address the budget deficit and the accompanying buildup of federal debt rather than pushing action back until after the November 2012 election.  In the latter case, S&P argues, legislation will be passed in 2013 at the earliest and probably won’t take effect for some time after that.

If it doesn’t see action, chances are it will downgrade Treasury debt from AAA.  It has also said that if congress doesn’t act like grownups, it may downgrade for that reason alone.

Downgrade is unlikely to come as a shock to an institutional buyer of Treasuries, domestic or foreign, who will have seen US government finances steadily deteriorate over more than a decade, from surplus in 2000 to the current situation.

In theory, downgrade means that the US will have to offer higher interest rates to induce investors to continue holding Treasuries.   Maybe, maybe not.

To my mind, there are two big practical issues with downgrade:

1.  The more important is whether/how the role of Treasuries in the working of global financial markets will change.  This is a question of the rules that financial players have to follow, either because of legislation in their countries or their contracts with customers.

Will institutional borrowers have to put up more Treasuries to collateralize a given transaction than before?  Will investment companies be forced by their contracts with customers to hold fewer Treasuries than before?  Will they have to sell, or just let their holdings mature and not reinvest?  How will this affect the ability of corporations to get short-term finance?

At the very least there may be a period of adjustment that reduces the speed of financial transactions–and therefore economic growth.

2.  The second is how domestic retail investors will feel about Treasuries after a downgrade.  Will they withdraw money from money market funds that concentrate on government paper?  As I mentioned in an earlier post, money market funds are already bracing for withdrawals by emphasizing the shortest-term securities.  This is having a negative effect on the ability of some EU banks to tap short-term sources of funds.

default

This is a separate issue from downgrade.  It’s much more serious.

Mr. Geithner has been careful to say that if the debt ceiling limit isn’t raised the government will default “on its obligations.”  This is very different from saying that the government will default on its debt–either by failing to make interest payments or by not returning principal on maturity.

Without the ability to borrow, the federal government won’t be able to pay 40% of its bills, or about $130 billion worth a month.  Given that failing to service existing debt would be disastrous–also, given the fact that interest payments on Treasuries are only a drop in the bucket at present–the Treasury Department would certainly have debt service as its number-one priority.  So, as a practical matter, default on government debt is out of the question.

Which bills don’t get paid?  The Treasury Department decides.  One open question is how sophisticated its computers are.  Can they, say, pay every government employee below a certain pay grade and no one above?  Can they sent out checks to Social Security recipients for 60% of their entitlements?  Can they do the same with all defense contractors?

The choices Treasury might have to make would all be intensely political.  …don’t pay Congress, but pay the administration and the courts?

From an investor’s point of view, however, no matter where the cuts come, they would represent an immense fiscal contraction.  Whether cuts happened by accident or design, the damage to the economy would be substantial.

I don’t think that stock prices, either in the US or the rest of the world, contain even the slightest discount for the possibility that this could actually occur.

Why the current weakness in stocks?

I think it’s mostly uncertainty.  Worries about a possible economic contraction are causing companies and state and local governments to put spending plans on hold.  Citizens who rely on Social Security or unemployment benefits are also likely conserving, to the extent they can.

I also think that some investors are looking back to the TARP debate, when it took a plunge in the stock market to persuade congress to vote to prevent the domestic financial system from failing.  So they’re raising funds on the idea that the same pattern will recur.  I suspect, however, that in the convoluted way that Wall Street minds work, other investors are taking the contrary position.  They’re saying to themselves that the obvious pattern is the TARP episode; therefore, that’s the least likely outcome in the present situation.

Who knows what will actually happen?  The only thing I’m confident of is that congress would come under intense pressure to act if the flow of money from Washington were cut dramatically.  A partial government shutdown might also lead to substantial turnover in congress in the 2012 election.  Therefore, I think a possible period of shutdown would be very short.