The Dilemma

Dilemma-"a situation in which a difficult choice has to be made between two or more alternatives, esp. equally undesirable ones."  {Thanks to Google's on line dictionary for this definition}

Investors right now are faced with a series of dilemmas, the situation in Washington and the one regarding their own investment portfolios.  We're going to discuss today portfolios.  Enough ink's already been spilled over Washington and in the end that's not what this blog's about.  Instead we'll deal with the choices as we see it regarding your money.

The game plan that most investors have been using regarding the debt ceiling and government shutdown debates is to look back at the summer of 2011 when we last had a similar event.  Back then stocks had rallied until April, plateaued during the summer as the rhetoric out of Washington came to a head and then fell 16% in about a six week period.  Stocks rallied out of that decline and never really looked back.  Buying stocks in August/September of 2011 proved to be a pretty good bet.  The S&P 500 is up nearly 50% since then.  Like now the economy was improving, inflation was tame and interest rates were low.  In fact interest rates collapsed during that crisis and have never really moved higher.  This came in spite of the credit agencies downgrading US debt from its previous AAA status.  

Similarly in 2013, stocks had a pretty decent rally at the beginning of the year and have since traded flat.  As I pointed out yesterday, stocks have gained no ground since May.  Stocks have now declined eleven out of the last fourteen days.  Yesterday was the first day though that it really seemed to matter to investors.  A lot of companies yesterday staged declines in excess of one percent.   This came as the Washington rhetoric became increasingly vile and the impasse between the two parties seemed to widen.  More stocks and ETFs are now trading below their 50 and 200 day moving averages and we are beginning to see some oversold signals in the markets {see this above attached chart from Bespoke Investment Group}.  

The investor's dilemma becomes what to do now.  If the 2011 scenario pans out then the markets are in danger of a further sell off.  If the markets need to have a double digit decline for Washington to pay attention then there is the potential for more downside risk.  Most investors would prefer not to see that sort of event take place.  There's also the complacency issue.  Wall Street right now assumes that the US will not default on its credit obligations.  While the probability of that event is still very low, it is not zero.  In fact there may be more danger of a default today than is assumed because the political parties in Washington are seemingly more polarized today than they were in 2011.  A default would catch Wall Street leaning the wrong way as the prevailing view is that some sort of deal will be struck at the 11th hour.  The 2008 market crash occurred in part because the Street assumed that the Government would not let Lehman Brothers fail and were therefore caught leaning the wrong way.  I'm not saying that a theoretical default will lead to a crash but I am suggesting that this is not the scenario most investors are currently assuming.  Should a default occur then it's likely that stocks at a minimum will be in for a period of volatility.

Yet when we step back and take a look under the economic hood we see a different picture.  A combination of low interest rates, lower energy costs,  advances in productivity and a rebound in housing suggest that the US economy is running at an improved rate versus 2011.  Were the Government's issues out of the way, we would be focusing on these things as opposed to potential fiscal drag.  In that world things look much better and the economy is expanding.  It isn't growing as fast as we all might like but there is nothing to suggest that the recovery is in jeopardy assuming Washington gets it's house in order.   On a rolling four quarter basis the S&P 500 is trading with a 14.2 PE and a 7.04 earnings yield.  This is on data that is a week old and may be somewhat at risk the longer the impasse lingers in Washington.  However, this is not data that's indicative of a wildly overpriced market on economic news.  Finally to sell substantial portions of portfolios not only brings in possible capital gains consequences {its been a pretty good few years now in stocks and there's likely substantial capital gains out there} but also runs the risk of the markets taking off with investors positioned with too much cash.

We are using the current environment to redeploy certain assets and to gradually invest cash positions, especially in newer accounts where we have not seen much opportunity to become more fully invested.  While understanding that there is the potential for some more downside in the markets, probability suggests that Washington will eventually resolve its issues.  The choice of not doing so will become too unpalatable for the political parties as this event wears on.  When the pain becomes too intense then we will see the outlines of a deal emerge.  

A few final notes.  We are not changing any of our indicators at this time.  I would also suggest from a tactical perspective that we are likely to see the rhetoric out of Washington get worse over the next week or so.  Look for the low points of this drama to occur over the weekend, perhaps coming to full froth on the Sunday morning talk shows {Meet the Press, Face the Nation etc.} I also would not be surprised to see temporary steps to avert a default as the 17th draws near.  Finally in regard to that October 17th date, don't set it in stone.  The real date is likely sometime between the 17th and the 1st of November when Social Security checks have to go out.

*Long ETFs related to the S&P 500 in client and personal accounts.