Investors Turn Cautious as Debt-Ceiling Fears Rise

BOSTON ( TheStreet) -- Investors are showing increasing concern over Congress's resolve to reach an accord on raising the debt ceiling by the Aug. 2 deadline and are showing that by selling stocks and building cash or gold positions, while others are waffling on Treasury bonds.

Their concerns stem from the congressional stalemate over raising the government's $14.3 trillion debt ceiling. Complicating matters is that as part of that, Congress and the White House also must agree to a deficit-reduction package to avoid a downgrade in the government's triple-A credit rating.

That sort of uncertainty creates volatility, which translates into larger price fluctuations that strikes fear into some investors but create buying opportunities for others.

Investors have gone back and forth on Treasuries this week, with some selling Treasury bills that were scheduled to mature within a few weeks. By Thursday, Treasury prices held on to modest gains after a sale of seven-year notes, which indicates that investors still have confidence in U.S. government debt. They sold at the lowest yield this year at 2.28%.

Many investors are heading for the sidelines and turning ultra-conservative. Gold futures reached a record $1,631 an ounce Wednesday amid concerns about the debt ceiling issues and the potential default of Greece on its sovereign debt.

Gold prices are expected to continue to rise until there's some resolution. Gold is up 14% this year, and is heading for its 11th straight annual gain.

The Standard & Poor's 500 Index is down 2% this week and down 1.2% in July, but is up 3.8% this year.

Standard & Poor's is sounding increasingly pessimistic over the resolution of the crisis and the potential repercussions. Its Investment Policy Committee warned in a report Thursday that "even though we still believe in 11th-hour miracles, we are beginning to feel like a boater attempting to restart an engine, while drifting ever closer to the falls."

The ratings firm cautions that investment strategists should not minimize "an adverse financial reaction should the U.S.'s (credit) rating be lowered, (by) rationalizing that the U.S. is still 'the safest bet on the planet.'"

Fidelity Investments' Dirk Hofschire, vice president of its Asset Allocation Research unit, wrote on the firm's website today that stocks are the most vulnerable to wild swings as the crisis drags on. "When uncertainty grows in advance of a potentially market-moving event, investors tend to gravitate toward less risky securities such as cash.

"Second, the impact of not raising the debt ceiling would be tremendously negative for the U.S. economy," he adds, as there is the threat of a double-dip recession.

But Morningstar analysts say they're "cautiously optimistic" for an outcome and note that "fundamentals are solid and there is still a great deal of cash on the sidelines that could move into the markets to fuel further gains" when a resolution is reached.

But if there isn't one or if there is just an extension of the deadline, the U.S. risks losing its triple-A credit rating which could create market disruptions and send Treasury bond yields higher, due to their perceived higher risk of default.

And that in turn would create market disruptions for other fixed income issuers because Treasuries are used as a benchmark for a large portion of the fixed income market. The end result would be higher borrowing costs across the fixed income markets.

Fidelity's Hofschire wrote that if no agreement is reached and the government was to default, the consequences will be dire. "If the U.S. were to stop its net borrowing overnight, the U.S. would in effect have to cut that 9% of (gross domestic product) GDP of government spending down to zero, which would be a massively austere fiscal adjustment that most likely would plunge the U.S. economy into recession over time. In my view, that would be negative news for stock prices because it would translate into rapid deterioration in corporate profits."

Todd Rosenbluth, a mutual fund analyst for Standard & Poor's, said in an interview that his organization has warned fixed-income mutual funds investors "that they should be aware that a credit downgrade could increase the risk profile of their mutual fund and so they will have to determine if they are comfortable with that exposure" since it could amount to a material change in their portfolio risk profile.

But Mark Travis, president of the Intrepid Capital Funds and a manager of more than $1.2 billion in assets, said he is confident that an agreement will be reached so he's looking for buying opportunities. "I'm probably in the majority (in that) I think at the end of day, they will work out some grand compromise and both sides will pat themselves on the back for saving the republic," he said of Congress and its impasse.

As for last-minute portfolio strategies, he said "it's a little too late to be defensive" in one's stock selection now, given the markets' recent decline.

Travis said his funds have been cash heavy recently, as much as 30% of the portfolio, because of the market's recent run up and in anticipation of volatility so he plans to use any dips as buying opportunities for select stocks with appealing valuations.

"We'll continue to invest" particularly as the market reacts negatively to the current events.

"Prices are up 100% from March 2009 and from our perspective, so are the risks," said Travis. "So we try to buy (stocks) that are beaten up that no one else wants" but they have long-term redeeming characteristics.

For example, he said a recent buy for the portfolio is World Wrestling Entertainment ( WWE), which produces and promotes wrestling matches on pay-per-view television. "People think the demographics (of its fan base) are what it's about, but really it is the valuation, which is driven by the media contract that they have in place" as that provides long-term revenue stability. The company also carries a hefty 4.84% dividend yield.

Another recent under-the-radar pick for Travis' funds is Regis Corp. ( RGS), which owns or franchises more than 12,000 hair salons across North America, Europe, and Asia. Its brand names include Supercuts and Hair Club for Men and Women.

Regis, which is seen as a relatively recession-proof business, has a market value of $881 million.

Kevin DiSano, senior vice president of IndexIQ, which offers index-based investment strategies, including a series of exchange traded funds that mimic hedge funds, said hedge fund strategies are a good way to limit downside risk and still gain regardless of the outcome of the debt ceiling debate. "You can hedge effectively by adding these to your portfolio and it's much better than sitting in cash."

His firm's $28 million IQ Hedge Macro Tracker ETF ( MCRO) which acts as a global tactical asset allocation portfolio, has 25% in cash, 23% in corporate bonds, 25% in foreign equities and about 10% in commodities including gold and silver, currencies, and emerging market bonds. It also holds a small short position on U.S. equities.

The fund is reweighted monthly to replicate what's going on in the hedge fund market, he said.

DiSano said it's also clear that investors are opting to invest in Asia to get strong equity returns. "There are pockets of opportunity," he said, including Japan and South Korea that are producing double-digit returns this year.

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