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 Confidence
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.
Treasury Securities
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.
Borrowing
Cost
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.
Equity
Markets
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.
Bond
Markets
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.