By Ryan Snefsky
Last weekend (July 23rd and 24th), the media obsessed over the idea that the Asian markets would get crushed if a deal to raise the debt ceiling was not reached by 4:00PM EST, which is shortly before Asian markets begin their trading day. Then they told us that the U.S. markets would get crushed if the Asian markets took a shot on the chin.
After the media's weekend long obsession, the Asian markets did not get crushed on Monday and neither did the markets in the U.S. On Monday, the Dow Jones Industrial Average closed 88.36 points lower at 12,681.16. On a percentage basis, this was only a loss of just under 0.7%.
Was all the obsession merely a negotiating tactic by our politicians to get a deal done faster? Maybe. But, I think even the politicians accurately expected the market's reaction Monday. If they actually expected something much worse, I think we would have seen a deal by 4:00PM.
Understanding why the markets reacted the way they did on Monday will help you understand what is likely to happen to your portfolio from now until August 2nd.
Stock market prices are largely based on what is likely to happen in the future.
In the case of the debt ceiling, Wall Street is largely concerned with the probability of the following two events occuring: the U.S. defaulting on it's debt obligations by missing interest payments and the U.S. defaulting on it's social and/or contractual obligations such as missing payments for social security / medicare / medicaid beneficiaries, defense contractors, and/or military salaries.
Knowing that the U.S. will not have enough money to pay all of its bills after August 2nd, it becomes reasonable to estimate that the probability of missing key payments goes up the closer we get to the deadline.
Maybe we can't put a definitive probability of 5% or 10% on the likelihood of missing a payment. But we can definitely assume that if the probability is X% today, the probability will be something higher than X% tomorrow.
The next important concept to understand is how much the probability of missing payments goes up each day. Interestingly, the probability does not go up by a fixed percentage with each passing day..
The probability of the United States missing a key payment after the August 2nd deadline increases exponentially as we approach the deadline.
The probability unfortunately increases exponentially as each day passes, because time remaining until any deadline always decays exponentially. This might sound a little confusing at first, but the following example simplifies what this means.
Suppose we're looking at a hypothetical deadline for something that's five days away. If one complete day of the time available until the deadline passes, we obviously have four days left. In this case, 20% of the available time has passed. We get this by taking one (the amount of days that have passed) divided by five (the total amount of time we had until our hypothetical deadline.)
However, if there's now only four days remaining in a deadline and an entire day passes, there's only three days left. When this second day has passed, the total time available was reduced by 25%, opposed to the 20% reduction we saw when we started with five days. We get this by taking one divided by four.
In each circumstance in the example above, we looked at reducing the total time available by one day. However, you can now see that a reduction of time available by one day becomes more and more significant as a percentage of total time available as we approach the deadline.
(On a side note, understanding this entire concept of how time decays exponentially can make you a lot of money with stock options. I'll save that for another post, however, as that is way beyond the scope of our discussion today.)
The stocks, or stock funds, in your portfolio will likely experience greater and greater percentage swings each day that passes until either the August 2nd deadline is reached or a deal, that the market as a whole generally finds acceptable, is passed.
The statement above applies to both upward and downward movements to your stocks. So if news comes out on Friday, July 29th suggesting that an acceptable resolution to this debt ceiling issue is truly likely to happen, you may very well experience a rise in the value of your stocks.
However, the percentage of that upward move would likely not be as big as if the news were to be announced on Monday August 1st.
On the other hand, each day that passes where it looks like this issue is in a stalemate, it is likely that the value of your stocks will go down. Additionally, the percentage of the downward movement will likely be more and more intense with each passing day because of the exponential effect time decay has on the probability of missing payments.
Now that you understand how this debt ceiling issue influences stocks, you can now see why the likelihood for total market devastation was not really that high on Monday, but becomes more and more likely as time goes passes.
This is even reflected in the data. While the Dow Industrials closed down just under 0.7% on Monday from the close on Friday, it closed down about 0.73% on Tuesday and down almost another 1.6% yesterday.
The moral of the story here is that losses are likely to get bigger and bigger each day until the deadline is reached or until a deal is made. If a deal is not reached by the deadline, we have a whole different situation on our hands that is beyond the scope of this post. We'll cross that bridge together if we get to it. In the meantime, expect a bumpy ride.
What are your questions about the debt ceiling and how it can affect your investments? Please use the Post a Comment form below to ask a question or leave a comment.
There is no chance they will miss a payment - they are making enough to pay the interest payments almost ten times over. Check out the numbers here:
ReplyDeletehttp://smallivy.wordpress.com/2011/07/29/what-will-happen-if-the-debt-ceiling-isnt-raised/
This is all political hype to scare people.
@SmallIvy - Thanks for both visiting and your comment!
ReplyDeleteI checked out your article that you referenced in your comment. I agree with you that the chance of an actual “default” on the debt, by definition, is quite low. However, I do take some issue with the the numbers you referenced as far as being able to claim that the U.S. can pay its interest 10 times over.
When you listed the income and the expenses of the U.S. budget, you listed annual numbers. If the entire amount of revenue was received in one lump sum on January 1st, the remainder of your assumptions would largely work out as stated.
The problem is that the revenues come in unevenly throughout the year, typically in the form of quarterly estimated tax payments from large corporations. While the revenues largely come in quarterly, the cash needs of the Government come in with very different intervals. The reason this is such a big issue right now is because the cash flow of the Government has come to a bottleneck here in August.
Warren Buffett has even accurately said that the August 2nd deadline would be a lot less crucial if several large corporations paid their September quarterly estimated tax payments a little early.
As of last Wednesday, the U.S only had $73.8 billion. Apple actually had more cash with $76.2 billion on hand. (See a CNN article on this at http://bit.ly/or5Sew).
The other cash flow requirement that I think may not be included in the budget numbers you listed is debt that matures this year. On August 4th, about $90 billion of debt comes due. Under normal circumstances, the Treasury would just issue more debt to pay off the existing debt. If the debt ceiling is not raised, however, the cash flow situation gets squeezed by an additional $90 billion dollars in this month alone.
While I agree with you that there is a lot of political hype surrounding this issue, some of which is blatently incorrect as we both know, this is not all political hype. Monthly cash flow is where the larger problem exists at the moment, rather than the annual shortfall.