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Deal or No (Debt) Deal - Here's What You Can Count On

Jul 19, 2011
Simon Maierhofer

Much ink has been spilled about the U.S. deficit negotiations. The market usually doesn't follow consensus views. For that reason, it will probably be better to forget the media's hype and focus on a different set of indicators.

A number of cliches come to mind when talking about the U.S. debt situation. The most appropriate might be: “You can’t have your cake and eat it too.” The least applicable is probably: “Never put off until tomorrow what you can do today.”

But if you think the U.S. will default on some of its obligations anytime soon, you don’t have enough faith in the government’s most potent weapon – extend and pretend (another cliche that’s become the modus operandi).

Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit. Chances are Congress will act again before the August 2 deadline. That however, isn’t good news.

By the end of this article you will know the common sense, no nonsense, deficit ramifications for the stock market and why even “a deal” isn’t good news.

USA Inc. – Income Statement

If the United States was a corporation – USA Inc. - here’s what the Income Statement would look like:

Total federal spending in 2010 amounted to $3.456 trillion. Total receipts added up to $2.162 trillion. USA Inc.’s 2010 deficit was $1.294 trillion. The two charts below provide a visual of income vs. expenses.

The 2011 federal budget is $3.7 trillion with a projected deficit of $1.6 trillion. But there’s no reason to despair, just before April 15, Congressional leaders were able to agree on $39 billion worth of budget cuts for the remainder of the year.

                                         

Senate Majority Leader Harry Reid hailed this heroic effort as a “historic” level of cuts. To quantify just how “historic” that effort was, we’ll put it in percentage terms -1%. The cut amounted to only 1% of the 2011 budget. Apparently it wasn’t enough. Thanks to extend and pretend, we’ve arrived at the next deadline.

Stocks Applaud … and Decline

Keep in mind that back in mid-April when the “historic” $39 billion cut was "hammered out" (this phrase make the mine cut seem like an herculean effort), the S&P was at about 1,300. Following the “resolution” of the budget problem stocks rallied about 5%.

The April 3 ETF Profit Strategy Newsletter featured the chart below (due to size restrictions the chart had to be reduced). As per the chart and accompanying analysis, the Newsletter expected a rally to the next Fibonacci resistance at 1,369, followed by a bounce off the Fibonacci support at either 1,229 or 1,255 and an attempt to take out the previous high.

                                                       

This outlook was based purely on technical analysis with no regard for the deficit problem or European debt woes (we’ll take a look at an updated technical forecast in a moment). The S&P did top at 1,370 on May 2. Thereafter it dropped to 1,259, and tried to take out the previous high (the S&P rallied as high as 1,356 on July 7and stumbled thereafter).

USA Inc. – Balance Sheet

If you think the Income Statement looks bad, you may not want to look at the Balance Sheet. Consensus estimates for unfunded obligations vary. Mary Meeker pegs the shortfall at $31 trillion, PIMCO’s Bill Gross estimates the unreported debt to be $75 trillion, while other estimates exceed $100 trillion.

The Deficit and Stocks

When President Obama took office in January 2009, the federal debt was 70% of GDP or $10 trillion. Today the debt is close to 100% of GDP at $14.3 trillion.  As per a recent AP report, President Obama had to scroll down his demands and would now be content with a $2.4 trillion deficit ceiling increase to make it last beyond the 2012 elections.

No doubt, the President would like the deficit issue put on hold until he’s re-elected. It seems like everyone has an agenda that takes priority over solving the actual debt issue. The whole game could be summed up as White House budget director Jack Lew put it: “That all these ideas do is say let’s kick the can down the road so that others will deal with it.”

This, by the way, is why the pre-election year of the Presidential election year cycles has seen gains consistently since 1939, because the incumbent party will do what it takes to remain in office longer.

A lose-lose Situation

The drawback of the deficit situation is that there is no easy way out. The government has to either cut spending (as in fewer benefits for Americans) or increase revenue (as in higher taxes).

Pick your poison. Either choice will slowly snuff out the economy. Of course, you can extend and pretend, which is probably what will end up happening. No matter how much lip stick you have at your disposal, a pig remains a pig. The deficit is a big (red) pig.

What is worse, a $14.3 trillion deficit today, or a $16+ trillion deficit (according to Obama’s wish) in 2012? Debt is like gangrene, dry rot or mold, it doesn’t just go away, it gets worse (ask Greece, Ireland, Portugal or any of the other PIIGS).

Eliminate Variables

Using European (NYSEArca: VGK) debt troubles as a benchmark, there hasn’t been a direct correlation between U.S. stocks and European debt. To generalize this even further, there hasn’t been a real correlation between the U.S. deficit issue and U.S. stocks.

It was in June 2009 that Greece admitted to having a “small” problem. Stocks rallied throughout the remainder of 2009, most of 2010 and some in 2011. The same is true for the MSCI EAFE ETF (NYSEArca: EFA) and Emerging Market ETF (NYSEArca: EEM).

Admittedly, the U.S. is a much bigger problem than the PIIGS, but the principal remains the same – basing investment decisions on the outcome of debt negotiations is tricky because the market has a mind of its own.

Since early 2010, every single time the major indexes a la S&P (SNP: ^GSPC), Dow (DJI: ^DJI), and Nasdaq (Nasdaq: ^IXIC) sold off more than a few percent, it’s been blamed on Greece. What many don't consider is that the market was helplessly overbought in January, and April 2010 and 2011 and due for a correction anyway. It seems like Greece has been a scapegoat more often than the actual cause. Perhaps it’s a game of chicken and the egg. Which came first?

No Chicken-Egg Game

It has been more beneficial and profitable to rely on solid technical analysis rather than playing the chicken and egg game.

Technical analysis along with sentiment readings pegged a market bottom of the same degree at S&P 1,259 – 1,245. Here's what the ETF Profit Strategy Newsletter said on June 15 (one day before the 1,258 bottom):

“The 200-day SMA at 1,257 is sandwiched between the 1,255 Fibonacci projection level dating back to 2002 and this week’s s1 at 1,259. Wednesday’s low was at 1,261.9. If this low is not enough, there is a strong cluster of support at 1,259 – 1,245. A drop into the 1,259 – 1,245 range would prompt us to close out short positions and leg into long positions” (long positions were closed out at S&P 1,345 on July 7).

There was no fundamental good news on June 15 or 16. Some of the headlines featured on June 15 were:
“Is the bull market over? A look at four different sentiment measures suggests that more pain may await investors.” – Barrons
“Greek default could trigger chain reaction” – AP
“Confidence is eroding among U.S. factories, consumers” – Bloomberg

We live in unique times. Unique times require unique measures. For the current market, technical analysis is the tool that fits the job. Rather than reading through every new morsel of information on the debt ceiling or fighting all kinds of cliches, it might be best to just focus on what’s been working.

The ETF Profit Strategy Newsletter provides comprehensive technical analysis that’s boiled down to actionable, easy-to-understand analysis and provides the support range that once broken will lead to a waterfall decline along with the potential target for this rally (if support holds).

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