The U.S. Economy May Be Doomed by the Debt Ceiling

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 |  Includes: AGG, AMZN, DIA, EBAY, FDX, MWW, QQQ, SPY, WMT
by: Clif Droke

In recent days the discussion in the financial press has turned to the possibility that the U.S. may default on its debt obligations for the first time in its history. As the debate in Congress rages on over the debt ceiling, investors are justifiably concerned that perhaps a stalemate in resolving the issue will unsettle the financial market. An even bigger fear is that a failure to reach a compromise measure by the Congress could trigger an economic collapse.

Let’s cast the rhetoric aside and focus on the primary issues which will determine the near term strength or weakness of the economy and the financial market. It’s important to realize that we’re in the historically dull summer season, which is famous for its lack of riveting news headlines. The country’s movers and shakers are on vacation and this is also a slack period for U.S. businesses known as the “summer doldrums.” For that reason, the mainstream media is faced with the problem of having to drum up eye-catching headlines in what is typically a dull news season. A quick survey of the latest headline news will underscore this point, viz. there’s nothing of interest going on out there right now.

This is where the imagination of the news media pays off as journalists are forced to dramatize what would normally be considered non-events. The debt ceiling debate, while an important one, falls under the category of a sensationalized story. Indeed, the debate as it has been framed by the mainstream press, has taken on the proportions of a life-or-death situation for the U.S. economic outlook. In reality the debate is rather cut-and-dried and has most likely already been determined by the leading members of Congress.

To begin with, the U.S. will most emphatically not default on its debt when, in the words of analyst Bert Dohmen, “There is more than enough money coming into the government every day to pay interest on the debt, social security, benefits for veterans, etc.” “Furthermore,” he adds, “Congress has many alternatives to get out of this.”

The absolute “proof” that a debt default and a consequent collapse of the economy won’t be happening anytime soon is found in a recent mainstream news article. The article was published in the widely read Huffington Post and was headlined, “Fed Secretly Preparing for Doomsday.” The article reads in part:

“The Federal Reserve is actively preparing for the possibility that the United States could default as a deadline for raising the government's $14.3 trillion borrowing limit looms, a top Fed policymaker said on Wednesday.

“Philadelphia Federal Reserve Bank President Charles Plosser said the Fed has for the past few months been working closely with Treasury, ironing out what to do if the world's biggest economy runs out of cash on August 2. Plosser added, "It could be very bad. At some level we don't really know what the consequences could be. It could be very serious. It could be less serious. Do we really want to run that experiment?"

Without even commenting on Mr. Plosser’s comments, the very fact this news article contained a prominent reference to the emotive term, “Doomsday” is a strong proof in itself that the worst case scenario (namely default) won’t happen. This is because of the proven relationship between strong headlines with doom-and-gloom connotations and the contrarian factor. That is, scary scenarios that are conjured up by the media never come to pass when they are framed in such gloomy, life-and-death terms.

As an aside, the fact that this article was given prominent attention on AOL’s newswire removes any veil of secrecy that the Fed may have had surrounding its preparations. Thus, the headline that the Fed is “Secretly Preparing for Doomsday” is no longer true since the “secret” is out. This is yet another example of media dramatization through the use of emotional headlines.

A couple of examples will suffice to illustrate the point I’m making. Back in 2007 a story circulated in the financial press explained that an unnamed European speculator had purchased a rather huge put option on the S&P 100 Index (OEX). The story came out during the July-August period when the stock market was coming off a rather sizable sell-off and the level of fear among retail investors was very high. The story circulating in the media at that time suggested that the stock market would collapse outright in September since this trader was supposedly “in the know” and was acting on knowledge that the U.S. financial market was approaching the crash point.

Instead of a collapse, however, the OEX quickly bottomed out and proceeded to rally in vigorous fashion into October, disappointing the short sellers who had bought into the dramatized story.

The next example was the later 1999 financial market experience. Heading into the final months of the 20th century, the media was incessantly beating the Y2K fear story. The implication was that financial markets would collapse should there be a Y2K crisis on January 1, 2000. The stock market wasn’t buying into this story, however, as the major indices were making new all-time highs right up until the end of December 1999 (see the NASDAQ chart below). This is another reason why high-profile fear stories should be taken with the proverbial “grain of salt,” especially when the leading indicators show no sign of believing the story.

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(Click to enlarge)

Another indication that the economy is no imminent danger of collapse is found in an indicator designed to provide a short-term economic outlook. It’s the closest thing I’ve been able to find that provides a reliable leading signal on the near term direction of the retail economy is the New Economy Index, or NEI for short. This index is simply an average of the weekly closing stock prices of five of the most economically sensitive stocks that also represent the main segments of the retail economy. The components are: Wal-Mart (NYSE:WMT), Fed-Ex (NYSE:FDX), Monster Worldwide (NYSE:MWW), Ebay (NASDAQ:EBAY) and Amazon (NASDAQ:AMZN).

I’ve kept the NEI for years and have been pleased with its performance for the most part. It has often provided a “heads up” on a significant change in the intermediate-term (6-9 month) trend in the retail economy; at its worst it is a coincident economic indicator but far ahead of the various economic indices published by the government in terms of showing real-time changes in the economic trend. Here’s what the NEI looks like as of its latest weekly update.Click to enlarge
(Click to enlarge)

The rules for interpreting the NEI are simple. As long as the index is in an upward trend the U.S. economy should be considered to be on a fairly sound footing in the short-to-intermediate term. Only when a reversal is signaled should we be concerned that the retail economy will weaken. A reversal occurs either when the NEI breaks below its nearest pivotal low or when the 12-week moving average (black line) crosses under the 20-week moving average (red line). Since neither of these things have happened yet, the main interim trend for the NEI should be considered up.

As long as the intermediate-term uptrend for the NEI remains intact there’s no need to worry about the economy’s prospects in the weeks ahead. Only when a reversal is signaled in the NEI will we join the mainstream media in worrying about the near term economic outlook.

Now what about the stock market? Should investors be concerned over the potential for a financially cataclysm induced by a possible default on the USA’s debt obligation? Now that QE2 is over, a major support for the market has been removed. The biggest support for equities right now is the 6-year cycle, which is peaking into the late September/early October period. That coupled with the residual liquidity still in evidence could keep the market within its year-to-date trading range until the cycle peaks. The extra fear premium which the scary headlines surrounding the debt ceiling debate have provided may also provide for some temporary short-covering rallies between now and the August 2 debt ceiling deadline.

The market is clearly under some weight on an intermediate-term basis, however, and as we discussed in our previous commentary the conspicuous lag in the financial sector stocks is a warning signal that rough waters are likely ahead for the broad market once we get closer to the 6-year cycle peak at the end of this quarter.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.