NEW YORK - Investors who behave conventionally are likely to get burnt if the political stand-off over the federal budget and the debt ceiling ends up forcing the US to default.
But portfolio managers and strategists say that if investors put their trading hats on, they may be able to protect themselves and even possibly come out ahead.
“The next two weeks could cause a lot of pain in many portfolios,” said Mark Yusko, chief executive and chief investment officer at Morgan Creek Capital Management, LLC, in New York.
One of the few things pros like Yusko agree on when it comes to the partial US government shutdown that began this week and the possible failure to raise the government’s legal borrowing limit by October 17 is that market turbulence is likely to rise.
US stocks retreated for a second straight day on Thursday as the shutdown dragged on and the dollar weakened broadly.
While the selling has been orderly so far, investors see anxiety rising if the weekend arrives without any sign of a political deal.
One way to take advantage of that, portfolio managers say, is to simply bet on more volatile trading rather than try to navigate the ups and downs of the stock or bond markets.
The CBOE Volatility Index, the world’s best-known fear gauge, hovered around 17 on Thursday, roughly a two-month high but still a far cry from 48, where it peaked in 2011, the last time Congress threatened not to raise the debt ceiling.
“Even a legitimate threat of a default will send volatility exploding – even to the 30s,” Yusko said. “You can make a lot of money in a short period of time.”
Yusko said investors can get exposure via the unleveraged iPath S&P 500 VIX, also known as the VXX, or the leveraged VelocityShares 2x VIX, or the TVIX.
For those who think it could approach 2011 levels again, snapping up a buy option now looks like a bargain and could be a nice way to hedge against losses elsewhere.
The same goes for buying options to sell the S&P 500 index, said Dan Greenhaus, chief global strategist at BTIG.
“The environments are certainly different, but given the similarities on the legislative side of things, we wonder why volatility hasn’t already begun moving higher,” he said.
Douglas Peebles, chief investment officer for fixed income at Alliance Bernstein, added: “Don’t short volatility. Because all roads lead to it. There is going to be less liquidity and more question marks about gridlock and growth. That’s painful to sit through, but it’s fertile ground” for increasing returns.
For longer-term mom-and-pop investors whose exposure to markets is concentrated in their 401ks, increasing cash holdings could offer some protection, particularly for older savers heavily invested in typical stock and bond funds.
Dan Yu, managing director of EisnerAmper Wealth Advisors LLC, said his clients’ portfolios are sitting on cash of between 10-12 percent, up from 2-3 percent in July. “We’re cash-heavy but I might be a buyer if we see a 5 percent pullback in the stock market,” Yu said.
After the 2011 debt ceiling fight ended with Standard & Poor’s stripping the United States of its AAA credit rating, the benchmark S&P 500 index had one of the most volatile years in the market’s history, logging the first zero percent performance in decades.
But as the credit crunch in 2008 taught investors, even cash isn’t safe when panic and forced selling ensue.
That’s because many money market funds invest in short-term cash equivalents such as T-bills, which could be most at risk if the US government goes into technical default.
Reserve Money Market Fund shares fell below $1 in 2008 when it was forced to write off debt issued by Lehman Brothers, whose failure marked the depth of the global financial crisis.
Investors have been avoiding Treasury bills that come due in mid-to-late October and early November, which have the highest risk of a default.
That has pushed one-month Treasury bill yields above those on longer-dated Treasuries.
One-month yields rose to 0.13 percent on Thursday, the highest since November, and well above the 0.02 percent three-month yield.
Reuters