With the headlines fixated on our country’s possible debt default, I want to focus on the markets regarding this matter.  Obviously, the prospects of a government shutdown and debt default can be frightening with unnerving propositions.  So, what would such a default really lead to, and what are the markets telling us?

In a worst case scenario, we “could” see ratings agencies such as Moody’s, S&P and Fitch downgrade U.S. debt.  Such downgrades would possibly be more damaging than the default itself as it would likely force increased selling pressure on all forms of U.S. debt, leading to higher interest rates and lower bond prices.  Additionally, because we’re in a slow economic recovery rising interest rates would slow our recovery further, as borrowing costs would go up for companies and individuals.

History does not give us many comparisons for our current dilemma.  But, it is worth remembering that we experienced government shutdowns in late 1995 and early 1996.  In those instances, the stock market performed quite will.   In fact, the Dow Jones was trading around 3800 in November 1994 and around 4900 at the time of shutdowns.

What we need to focus on is that the markets are a “discounting mechanism”.  In other words, much of the fear of a shutdown was already “baked into the cake” in 1995 as the markets had anticipated a shutdown and adjusted/discounted  accordingly.  Of course, the prior results do not guarantee a positive outcome, but it does serve as a helpful antidote.  What the markets cannot discount are occurrences and events which are truly unexpected and unanticipated.  The markets know this issue is looming and arguably, investors have already discounted accordingly.  Case in point, the S&P 500 is currently off about 5% from its highs and the markets have essentially gone sideways since January.  This is against a backdrop of improving corporate earnings, with much of this scenario is already built into the markets.

At the end of the day, the capital markets are signaling that America will not default on its obligations.  While our current situation itself is disconcerting, it should not have a very long lasting effect because corporate earnings, not politics, drive the capital markets.

Our global expansion appears to be slowing, which is the result of an enormous array of factors.  While the slowdown is a bit disconcerting, it is not a surprise.  Economies and markets typically “stair-step” higher and, at this point, we are on a plateau.  That said, we saw a similar scenario last summer and it will not surprise us to see the economy reinvigorate again this fall in much the same fashion as 2010.  Thus, we feel this resilient market could head higher over the next 12-18 months.

Money is always looking for perceived opportunity and value.  While the U.S. economy has certainly slowed and faces headwinds, the commerce of the United States still leads the world in perceived opportunity and value.

Consider:

In May the U.S. added only 54,000 new jobs.  It was  some 100,000 fewer than the 150,000 expected.  But we did not lose 150,000 jobs and we are not expecting to lose another 150,000 or 200,000 this month.  Even at this slow pace in January 2012, 1.5 million people who were unemployed in January 2011 will have jobs.  This means higher consumer spending and  higher demand for housing.

Housing continues to be soft.  But, with that weakness, it is by definition a much smaller percentage of GDP.  So, the drag to future GDP growth, even with persistent weak housing, will not be as much of a negative impact as it was in 2008 and 2009.

As monies continue to chase perceived opportunity, those monies will invariably flow into the markets.  Even though as redicted, the market has recently flattened out, we expect to see a higher market by the end of 2011, and thus end the year with some nice gains.

The markets ran up to start the year, but now appear to be losing a bit of steam.  Earnings have been strong and, to this point, the economy has been improving.  However, in our most recent economic reports, we are seeing the economy flatten.  We saw a similar scenario last summer.  It’s our hope and belief that we will reemerge from this correction with once again an accelerating economy going into the end of 2011.

Additionally, we believe one of the sectors that offers a lot of value from these levels is the financial services group.  We have begun to build positions in the group and feel that this is a space that can make us strong long-term profits.  Our desire is to build our positions over a few months to relieve any short-term market volatility.  We are positive on this sector for several reasons:

 Financial services companies are most profitable when we are experiencing a steep yield curve, as we are today.  Interest rates are very low, from a historical standpoint, but the spread between short rates and long rates is wide.  Remember, banks borrow short and lend long and low rates give these companies a quasi-free source of capital. 

About 40% of the S&P 500 is comprised of companies that work in a financial services capacity.  We find it hard to believe the markets will do well without this sector participating.  Our bet is they will begin to lead. 

Banks and financial services companies are once again loaning, which is a huge positive.  In fact, the Federal Reserve recently made note of this in one of their meetings. 

 In the end, we are probably a bit “early to the party” in our financial services investments.  However, as we have seen with other groups like gold, the lion’s share of the gains are typically made by being early, not late.

As the markets opened we were greeted with the news that Standards and Poor had lowered its “outlook” to negative for our nation’s long-term debt, with a potential downgrade of our AAA rating a real possibility. 

 This event has several implications. First and foremost, it should send a message to all our elected leaders that the days of politics as usual must come to an end.  While there seems to be almost universal acknowledgement of the unsustainability of deficit spending and runaway national debt, little is being done to rein it in.  Such behavior is obviously disconcerting.  As citizens and patriotic Americans, we must all insist that in order for a candidate to get our vote, there must be a real commitment to serious fiscal reforms.

The market’s reaction to the news resulted in a hard selloff.  Ironically, history has shown us that, while both the equity and debt markets experience selling pressure with such news, the equity markets substantially underperform the debt markets. It seems a bit odd in that the potential downgrade is coming from the debt side, but such is life in the capital markets. 

The current market correction will most likely last somewhat longer than it would have without such news.  In the short-term, we seem to be falling under the guise of the adage “buy the rumor, sell the news”.  In other words, the markets had a nice run up to start the year in expectation (rumor) of good earnings reports.  With the news being reported, the markets are correcting (selling), with profits being taken.

It is our intent to take advantage of this corrective phase depending on the level of the correction.  We continue to believe the markets will finish 2011 with positive returns.  The main caveat to that is, however, the price of energy.  As investors have flocked to buy energy, it has obviously driven up the price of oil.  If prices continue to raise much above the $110 a barrel level, it will hurt the consumer, slow the economy and create a less attractive stock market.

With the recent tragedy in Japan, our thoughts and prayers go out to her people.  Obviously, the aftermath of such a tragic disaster not only brings immense personal suffering, but also ushers in a time of economic instability, uncertainly and concern.  In light of these events, we have received several calls and emails from clients regarding what impact the Japanese earthquakes would have on world markets, so we thought it would be timely to address the issue. 

Japan, like most countries in our post recession economy, has been struggling to regain its economic sea legs.  The recent natural disaster delivered a punch of historical proportions.  In our mind, the question becomes, “Will this disaster be a knockout blow or another setback before a painful recovery?”  We tend to believe it will be the latter, primarily because Japan is a nation of resilient, determined and efficient people.  We saw a similar situation in Japan after WWII, and following the 1995 Kobe earthquake.  In each circumstance, the people of Japan received it as an opportunity to rebuild, modernize and encourage growth of new economic activity.  We have no reason to believe this time will be any different.

As it applies to the US, the overall effects on our domestic economy should be somewhat limited.  U.S. exports to Japan are less than 5% of our total exports.  However, the issues in Japan will most likely cause supply disruptions for specific industries, such as auto and semiconductor.  In fact, GM has already started seeing the effects of this supply shortage and had to shut down production in several areas.  Thus, while it may not have an overwhelming effect on our economy, it does raise a red flag in several sectors for us to avoid. 

In the end, the issues in Japan are disconcerting, but on the investment side, we must keep our “eyes on the prize” and that prize is economic growth.  Our economy continues to improve, as evidenced by the recent round of corporate earnings and economic indicators such as manufacturing growth.  We have been communicating with you over the last several months that we were due for a correction as the markets were stretched.  We believe that such a corrective phase is now underway.  That said, our economy is continuing to improve and this should lead to higher markets later in the year. We expect this correction to give way to higher prices later in the year and we will attempt to use the volatility to our favor.

In our March 2008 client letter, we stated:

“In spite of all the difficult times, our economy has always cycled back to prosperity.  Economic cycles, such as our current slowdown are the inevitable and natural result of a free economic system.  Without the ebb and flow of commerce, there would be no opportunity for successful investing.  Our Delta accounts are well positioned to take advantage of what we believe could be a time of very favorable upscale opportunity.”  That was 3 years ago…

So… what has actually happened?  Well the good news is the markets have indeed cycled back and doubled from where they were in 2008.  The only other times in our market history when we have seen a run this substantial and this quick was once in 1937 and once in 1939.

So… where do we go from here?  We believe, we will trade higher in a longer-term sense.  But, discretion being the better part of valor, we feel it may be time to take a few chips off the table in the short-term.  The economy is showing signs of recovery and it appears that job creation has begun.  That said, we are seeing a few short-term headwinds emerge: 

Oil and food prices are on the rise raising the specter of inflation.  Raising inflation, of course, is something which could act as a catalyst for slower consumer spending and mire the economy.

Interest rates are rising which is bad news for bond holders.  If they continue on their current path, it could also represent another drag on business and consumers.  Understand in this context, rates are moving higher from historically low levels. Thus, we are not overly concerned in a long-term sense.  Higher rates will also further dampen any recovery in housing.

Our expectations at this time, point to a market which will soon start a corrective phase.  We remain bullish longer-term and think the next couple of years will be good ones in the markets. 

However, if inflation heats up and interest rates continue substantially higher, they will come to public light sooner rather than later, and will almost certainly act as the driver for a short-term correction.  As a result, we my start taking some profit and raising cash.