3 Ways Investors Can Navigate the Debt Ceiling Standoff
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The U.S. government hit its debt ceiling Jan. 19, which, according to the Treasury Department, could lead to a default as early as June 1 — the so-called X-date.
President Joe Biden and House Speaker Kevin McCarthy, R-Calif., have resumed meeting in hopes of hammering out a deal to avoid a self-inflicted economic catastrophe. Should they fail to come to terms, the default would likely lead to a major selloff of U.S. bonds, unleashing what would be, by expert accounts, a potentially apocalyptic panic that would disrupt economies around the world.
No pressure, right?
To be sure, history tells us the debt ceiling standoff will not end in catastrophic default. Biden and McCarthy have said they want to avoid that outcome, and the pressure is on for an agreement before June.
But as talks drag on, uncertainty could roil the stock market. A full-on crash is unlikely, but should there be short-term volatility, stock investors can take these steps to prepare their portfolios.
1. Keep a historical perspective
This isn’t the first time the U.S. has had to raise its debt ceiling. In fact, it has done so 20 times in the past 20 years — and 78 times since 1960.
But one event in particular could be worth remembering if stocks plummet: the debt ceiling crisis of 2011.
Like the current showdown, the Republican-led House in 2011 refused to raise the debt ceiling without Democrats first agreeing to cut federal spending. Neither party could reach an agreement — until 72 hours before the X-date.
A few days after the debt ceiling was raised, S&P downgraded the United States' credit for the first time — from AAA to AA+ — making it more expensive for the world’s largest economy to borrow money. This, in turn, led to a stock market panic: The S&P 500 dropped 6.7% in a single day, culminating in a 16% decline from that year’s high in July.
We now know this was just a wobble near the beginning of the longest bull market in history, which began in 2009 and ended in 2020. In fact, after the S&P 500 finished 2011 flat (no gain; no loss), it began a three-year hike that saw a 13.41% gain the first year, a 29.60% gain in the second and a 11.39% gain in the third.
Of course, our context in 2023 is different from 2011, and many additional factors are weighing on the stock market, including the likelihood of a recession and high borrowing costs afflicting companies. Even so, history tells us it’s advisable to resist panic selling: Somehow, those knee-jerk reactions always have a way of coming back to haunt us.
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2. Cut back on margin trading
With all the uncertainty facing the market, 2023 might not be the best year to buy stocks on a margin.
As a reminder, margin trading involves borrowing money from your broker to buy more stocks. Depending on your creditworthiness, most brokers will allow you to borrow up to half your total purchase of stock.
Imagine, for instance, that you buy $10,000 of a stock that gains 100%: You’d be left with a $20,000 holding. Now imagine you had borrowed $10,000 to own $20,000 of the same stock. By the end of that 100% gain, your holding would grow to $40,000. You would be left with $30,000 (after you pay the $10,000 back to your broker), minus any fees or interest your broker charges for margin trading.
But margin trading doesn’t always work in your favor, and in volatile markets, you can lose more than your original investment if a stock declines 50% or more.
For example, let’s say you borrow $10,000 to double your holding of a stock and its price drops 75%. Your $20,000 holding is now worth $5,000. You still owe your broker $10,000, which means you’ll have to cough up another $5,000 if you cash in your $5,000 holding now.
Typically, margin trading sees more success during bull markets. But as we lead up to the X-date, short-term volatility could make most stocks poor margin investments. Plus, with the interest rate on your margin loan — and the fees — a bear market and potentially catastrophic default likely won’t create the conditions to make margin trading worth the risk.
3. Have cash in your brokerage account … just in case
Finally, if you’re a value investor, you might want to keep some uninvested cash in your brokerage account. As we march toward the X-date, short-term volatility may temporarily devalue some great long-term stocks. If that happens, it could be an opportune time to buy shares at low prices, especially if the company has strong fundamentals.