How US Debt Impacts US Stocks, Stock Market – Over or Undervalued, 10 Things You Need to Know from a Hedge Fund CEO
Alpesh B Patel OBE
Asset Management CEO. 18 Books, Bloomberg TV alum & FT Columnist, BBC Paper Reviewer; Fmr Visiting Fellow, Oxford Uni. UK Govt Dealmaker, Dept Business & Trade. alpeshpatel.com/links Proud son of NHS nurse.
15 NOVEMBER 2021/02:00 PM-03:00 PM
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On October 12th, the U.S. House of Representatives approved legislation that temporarily raised government borrowing limits to $28.9 trillion. This action has staved off the prospect of debt default until December.
President Joe Biden will sign the measure into law before October 18th, which is the day the Treasury Department calculated it would no longer be able to pay U.S. debts without congressional action.
But how did it get to this? And what does this mean for the broader economy and U.S. stocks?
What is the U.S. Debt Ceiling?
Late September and early October 2021 have been anxious times for the U.S. economy. Congress faced a tricky task: reach a deal on the U.S. national debt ceiling, or the government would run out of money to pay its bills. Failure to do so could lead the U.S. to default on its debt, which has never happened before.
While this prospect has been put off until December, a solution needs to be found. So far, Republican and Democratic lawmakers have been at odds over raising federal borrowing limits, also called the debt ceiling.
Before the temporary agreement, the debt ceiling stood at $28.4 trillion. However, the national debt, which is the total that the government owes creditors, was $28.43 trillion.
With the October 18th deadline looming, a stopgap bill was required to prevent the first default. Failure to reach an agreement would have meant that the federal government would default on its obligations, including Social Security and payments to veterans.
The debt crisis was causing some nervousness in the U.S. markets. Republicans had been expected to block a third attempt to raise the debt ceiling. However, fears eased slightly once Mitch McConnell, the Senate Minority Leader, indicated his party would support the debt ceiling extension into December. Additionally, McConnell's announcement caused yields on one-month Treasury bills to drop.
What Would Happen If the U.S. Defaulted?
Congress may have kicked the debt ceiling down the road for now, but an agreement still needs to be found. Otherwise, the U.S. faces the prospect of a government shutdown.
Stock investors won't be delighted about this prospect. Several headwinds are swirling at the moment, like Federal Reserve tapering. Analysts at Goldman Sachs have suggested that shutdowns don't necessarily spell bad news for the market. However, several other factors could affect stocks.
Goldman's analysis shows that government shutdowns have historically failed to have a meaningful impact on equity returns. There have been 14 government shutdowns since 1980. During these shutdowns, the S&P 500's median returns were:
- -0.1% on the day of the shutdown
- 0.1% during the shutdown
- 0.3% on the day of the resolution.
The only exception was the most recent shutdown during December 2018. During this time, the S&P 500 dropped by 2%. However, as Goldman notes, this decline was more likely driven by investors' fears about Fed tightening.
While budget expiry doesn't have a considerable effect, debt limit deadlines do affect some parts of the market. Government revenue exposed stocks — like industrials and health stocks — underperformed the market during the 2011 and 2013 debt limit deadlines.
If the government can't find a debt ceiling solution by December, these stocks could be affected again.
What Else Could Rattle Equities?
Goldman strategists suggested that the macroeconomic picture is a better predictor of how the equity markets would respond. During the 2011 and 2013 debt limit shutdowns, the S&P fell in 2011 but rallied in 2013.
The big difference between these two was the broader economic situation. In 2011, there was declining economic growth, the S&P had downgraded U.S. sovereign debt, and the European debt crisis. By contrast, the conditions in 2013 were more favorable.
The macro picture is causing some concern heading towards the fall. Global markets rose last week as the U.S. waited for Labor Department data. However, tdon'tcan'tdoesn'tinvestors'500'sGoldman'sere is hope for the broader economy.
Conclusion
Historically, debt limit deadlines don't have a significant impact on the S&P 500. However, some caution is the market should be expected if Congress struggles to reach a more permanent solution to the borrowing limits problems. For now, though, the biggest fears for equities come in the form of the energy crisis, Fed tapering, and concerns about GDP.
Since the post-pandemic stock market boom, analysts and experts have warned us that the market was overvalued. Some have gone even further and submitted that we’re in a bubble that is set to burst. However, prices keep rising, suggesting many investors believe there is still value to be found. So which is it? Is the market over or undervalued?
The Case for an Undervalued Market
While the S&P 500 has hit record values since the stock market dropped during the early stages of the coronavirus, the FTSE 100 has yet to recover fully. The drop of around 14% left a long way back; however, values have steadily increased by about 5%.
A successful vaccine rollout and an easing of Brexit anxiety have made a big difference. In fact, for the first time in five years, investors are at an equal weight on the market.
However, despite all of this, the market remains at a significant discount. According to the broker Peel Hunt, the 12-month forward P/E is 25% cheaper than the eurozone and 40% cheaper than the US markets. So, all things being equal, it seems like Brexit economic fears still exist.
The case for the US stock market being undervalued may be more challenging to make, primarily because it keeps hitting all-time highs. However, some analysts believe bad maths and mistaken presumptions are behind the doomsday predictions.
In fact, John S. Tobey writes in Forbes that instead of using the P/E ratio, we should use the Earning/yield (E/P) to value stocks. He firmly believes that if we make this adjustment, the market is undervalued.
The Case for an Overvalued Market
As always, there are plenty of voices who believe the market is overvalued. Additionally, two reliable measures of the market suggest the market is overvalued.
The Shiller P/E Ratio stands as 38 times. This number is close to the peak of 44 that it hit during the stock market boom. Strategists at SunDial Capital Research have said that historically a number over 25 is a precursor to significant market corrections. However, they have stopped short of issuing sell warnings.
The second valuation metric that is giving out warnings is the “Buffett Indicator,” which takes the Wilshire 5000 Index and divides it by annual GDP. It currently stands at 238%. To put it in context, the value was at 159.2% before the dot com bubble burst. However, it’s worth noting that this time might be different because interest rates are at historic lows.
Conclusion
Current monetary policies are keeping interest rates low. This situation punishes savers and those who invest in low-risk options like bonds. Conversely, it has a favourable effect on the stock market because it is one of the best places to invest money.
Anyone who is retired or close to retirement should consider investing in the stock market. Options like ETFs are a great way to get started due to their simplicity. Additionally, they don’t have investment minimums or excessive charges like most mutual funds.
My guide will give you a taste of being your own broker
All those kids’ thinking they are part of a political movement against hedge funds. Wait till they discover two things — first, we have no problems jumping on the back of the price moves they or anyone else creates.
Second, as probably the only retail trader in the world who actually then became a hedge fund manager — it’s not all it’s cracked up to be (more on that later).
Heck, I even wrote THE definitive book on trading that the Financial Times published. Each week in the paper wrote my Diary of an Internet Trader column.
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What brokers do
Realising that 78% of retail clients lose money (See risk warning on any UK regulated broker — US figures would be similar). They decided to be the Casino house instead.
If the retail clients act in concert, some brokers, of course, will trade alongside them if they know those clients have a track record of success — but they don’t have that data with the new accounts.
I’ve worked with a lot of brokers as an online trading authority thanks to all my books and actually doing it for a living.
For the good brokers— reputational and liquidity risk are the two most important things to them.
And if these new accounts act in concert, i.e., conspire to manipulate the price, the broker can fail to be on the other side. So they will increase their margin to 100% to avoid this risk.
Why should a broker bankrupt themselves? Only an entitled millennial would think they have the right and blame the boogie man for stopping him from playing with his top computer.
2. Yes, you could be in the 22% who become winners and set up their Cayman Domiciled hedge fund as I did, but more on why that is not the dream in a moment.
3. Reputational risk brokers don’t like the death of clients, for instance. A Robinhood client committed suicide last year. So again, they place restrictions.
Alpesh Patel on BBC — Seen It All Before
What it means for the UK
4. The UK could suffer more than the US. In the US, most use options to gain leverage. A long call that increases in value as the share price rises will, at worst, cause you to lose 100% of your deposit. No more if the price collapses or the option expires.
In the UK, most trading in this type of stock is done on CFDs or Spread bets. So the broker will allow you to put down some margin and loan you the rest to cover the underlying notional value of what you bought.
Alpesh Patel’s Diary of an Internet Trader Column in the Financial Times
How Hedge Fund margins are calculated
This margin is calculated in the same way for hedge funds who also use CFDs — whether given volatility will the broker be able to demand and get funds from you. If the trade goes against you and if not, have ample time to sell your position and recoup the monies they are owed.
But this means you could easily lose more than your initial margin deposit.
Alpesh Patel Campaign www.campaignforamillion.com
Statistically, even Microsoft is more likely to be down in 25 days than in 250 days. So the likelihood of a margin call in a more volatile, less dependable company is greater, and the broker could be exposed.
Anyway, bottom line — UK traders are more exposed than US ones. Thankfully UK brokers are stricter gatekeepers (generally) to who they allow to trade.
5. This is not a paternalistic/libertarian movement — let us get rich, barbarians at the gates, like the kids, like to think. When they lose money, they will cry, “Why did no one stop us?” Wait, it’s coming.
6. Yes, in concept, colluding, you can make any price, even Bitcoin and Gamestop become the world’s most valuable asset (well, highly-priced asset anyway). That angers people, boomers, who know the difference between price and value.
7. Any hedge fund shorting liquid stock does not have your pension fund as investors. They wouldn’t be allowed. That they did it is a lawsuit waiting to happen too.
Managing your hedge fund risks
8. Yes, 22% or so do make money. More than in a Casino and more than as entrepreneurs, given that 90% of new businesses fail in 3 years. But as I’ve written in the Financial Times, it’s not the headline that helps make money, but risk management.
There is something the kids are on to; it’s just their raw talent for working out the internet, social media, communication online is being wasted. They are going into battles (not against hedge funds) but without the training.
Yes, derivatives like options and CFDs are weapons of mass financial destruction — which is why these kids should train themselves for their own financial well being.
Long term problems
9. The more significant problem will arise when they co-ordinate to short the S&P500. Never in history have so many had so many communications to do so much damage with so little money.
A flash crash is more than 50% likely, tripwires will kick in to halt trading. And there is a more than 50% chance these keyboard warriors will make a company like GameStop the most valuable in the world.
And who knows, GameStop will raise money on the markets and make solar panels and be worth it.
After a year like 2020 and the way 2021 is shaping up — I am not in the forecasting business.
More about Hedge Funds
If I were a millennial today, and I’m in my 40s, having left practice as a barrister to trade full-time, then set up my hedge fund after some success. I’d go into fintech — sell shovels to brokers and their clients.
In fact, my hedge fund does — that way, you win either way.
Trust me, raising capital for a hedge fund from outside investors is tough — I know! Pull out the world’s tiniest violin.
Don’t get me wrong, being a hedge fund CEO has been great; it’s allowed me to serve my country, meet the Royals, go to Number 10, bring investment to the UK.
Being a hedge fund CEO has allowed me to serve my country, meet the Royals
But I’d do fintech today, so maybe if they crush my industry, it may not be a bad thing. A lot of clever people will go into doing public service and tech to solve bigger problems.
Wanted to share some of the latest developments with you all.
Webinar: As the US stock markets hit all time highs you will want to watch my latest webinar on that and much more: https://lnkd.in/dQ6xNn29
Books on Investing: I was at London Investor Show and whether you were there or not for my talk: the free books are at https://lnkd.in/eyWfduP
Instant Messenger on Markets: The free instant messenger for around 5 videos/articles daily from me, Financial Times, Bloomberg is at https://t.me/pipspredator
Articles: These details articles you will find immensely useful too:
-How we got 100% returns in the past 12 months on some of our stock picks https://lnkd.in/dSr-FdWs
-My article on common investing mistakes to avoid before retirement https://lnkd.in/dP8ktdvA
How does US Debt impact stocks and which may benefit is here. https://lnkd.in/eQAXDjn8
As so many people are worried about supply chain disruptions, I have provided this analysis on impact on stocks: https://lnkd.in/ewvJdXhJ
And this one goes into why women make better investors, but also why so few invest. https://lnkd.in/dSbpse4K and https://lnkd.in/dErUtj3G
Finally lots of research on whether FAANGs are overvalued. https://lnkd.in/dydSNEzc