Wednesday, October 09, 2013
HOW CAN THE MARKET REACTION TO THE GOVERNMENT SHUTDOWN AND DEBT CEILING DEBATE BE A GOOD THING FOR INVESTORS?
Market reactions to the uncertainty surrounding the partial U.S. government shutdown and debt ceiling debate have been highly predictable, with all major indexes showing steady declines with each passing day. On Tuesday October 8th the S&P 500 index closed at 1,655.45, down 20.67 or 1.23%. The Dow Jones Industrial Average closed at 14,776.53, down 159.71 or 1.07% and the NASDAQ Composite closed at 3,694.83, down 75.54 or 2.00%. The value of the U.S. dollar has also declined against most major currencies. However, this may be good news for long-term investors.
Between the government shutdown and the debt ceiling debate the one that scares investors the most is the potential for the U.S. government to default on its debt if the borrowing limit is not increased, and there are plenty of reasons why investors should be scared, however unlikely the threat of default:
Consumer spending drives the economy and when confidence in the economy is shaken spending drops significantly as consumers and businesses alike begin to horde more cash. This also results in fewer investments, driving the value of securities down.
Governments and banks around the world hold U.S. Treasury securities. They account for about 11.6 percent of total public debt. The Social Security fund holds nearly 30 percent of the outstanding securities. Not only would a debt default destroy the U.S. finances, but it would also damage the fiscal houses of governments and banks around the world.
As the U.S. Treasury has explained, “Investors’ willingness to lend to nonfinancial corporations is often summarized by credit risk spreads — that is, how much higher yields on private securities are than yields on comparable maturity Treasury securities. If investors are less willing to invest, they demand a higher return for that investment. From the borrowers’ perspectives, wider credit spreads imply a higher cost of funding for a given level of Treasury rates. Higher funding costs lead to less spending on investment or other outlays that are financed.” In a nutshell this means that interest rates will rise, investments will slow, and the economic recovery will be at risk.
Economic uncertainly creates volatility in the markets. Increased volatility can cause investors to exit the market, driving the market down, in addition to and causing households and businesses to reduce spending. During the last debt ceiling standoff in 2011, the S&P 500 fell about 17 percent.
Markets are all interrelated with the solvency of the U.S. Treasury being the glue that holds them all together. In the event of a default bond prices will plummet as interest rates increase.
All of these possibilities are already rankling investors, as shown by recent trading. However, there is a silver lining that many investors fail to see, yet one that the most successful investors regularly recognize—opportunity.
Warren Buffett follows the rule, "Be fearful when others are greedy, and be greedy when others are fearful." Essentially this means that when the market spikes you should be more conservative in your investments due to the potential of downward correction resulting in losses. The flip side of that is when the market dips then you should take advantage of the lower prices, expecting an eventual upward correction resulting in gains. It’s not rocket science, yet many investors fail to understand and heed this advice.
Buffett recently provided proof that this advice works. During the Great Recession Buffett invested $25 billion, mostly into large companies having significant financial troubles at the time. Companies like Bank of America, Mars/Wrigley, General Electric, Dow Chemical, and Swiss Re. As a result, he recently disclosed that those investments have netted Berkshire Hathaway a profit of $10 billion during the somewhat modest recovery thus far, including a $300 million yearly dividend from Bank of America alone!
While it’s likely that you lack the financial resources of Warren Buffett, your portfolio can still benefit by using this strategy. If you typically invest a set amount of your income each month, refusing to reduce your investments in a market dip will result in similar returns when the market recovers. If you have additional disposable income to invest during a dip, then doing so will result in even greater returns in the future as the economy improves.
The trick to using this strategy is to remove emotion from your investments and invest when you have time on your side. When investors become scared and exit the markets en masse, instead of following suit like a lemming over the edge of a cliff, double down on your investments. Additionally, as investors are regularly advised, the more time you have to hold onto your investments the better returns you will reap. That’s just one more reason why you should begin to grow your investments early on in life. Doing so will allow your investments to weather the storms and provide gains when you finally need them in retirement.