In the Sunday edition of the San Francisco Chronicle yesterday, the front page headlines were “Big Drive to Tailor Firearms to Owner,” No Mothers Among City Fathers,” “Basketball Great is Still a Warrior After 50 Years,” and “Get Back In the Game and Fight, RoveTellsState’s Republicans.” What is glaringly not there is the following headline: “Sequestration – $85 billion of Indiscriminate Cuts – 750,000 Jobs Lost – Rising Risk of Recession.”
It is one thing for the San Francisco Chronicle to entirely ignore a national economic issue. It is another for the Dow Jones Corporation, publisher of the Wall Street Journal and Barron’s, to do the same. The cover story on Barron’s this weekend was “Calmer Seas Ahead.” Clearly fear mongering and scare tactics regarding government cutbacks don’t sell newspapers currently.
While the media often misses the obvious, the stock market rarely misses anything. On Friday, the Dow Jones Industrial Average (DJIA) advanced by 35 points to close at 14,089.55, not far from its record high of 14,164.43. People on both Main Street and Wall Street agree, automatic federal government budget cuts are either a non-issue or a positive for the investment landscape.
The $85 billion of mandated cuts represent half of one percent of U.S. GDP – not a big deal. In the chart on the right below, it shows federal government expenditures as the orange line and tax receipts (“revenues”) as the gray line. You can see the spread between the orange and gray lines is the widest it has ever been since 1960. The positive is at least the government is making some effort to cut, even if it is inconsequential.
The bar chart on the left shows a more disturbing picture. It shows that of total government spending, roughly 64% is spent on Medicare/Medicaid, Social Security and Defense. These three expenses represent roughly $2.3 trillion which is nearly all of the tax receipts of the government. In other words, if entitlement and defense spending is not reduced and revenues remain roughly constant, there is no money for discretionary non-defense spending and debt service by the government. All discretionary government programs would have to be eliminated for the budget to be close to balancing.
Incorporated in the numbers is a potential time bomb. With interest rates near record lows, interest payments on debt are not a major portion of the budget currently. In a rising interest rate environment, debt service could make the government deficit significantly larger and force extreme austerity measures. While the Sequestration is a step in the right direction, it is a baby step.
The next step which is likely to be a bigger step comes on or before March 27. March 27 is the date when the continuing resolution to keep the federal government operating without a budget expires. The formal debt ceiling due date for a modification higher is scheduled for May. These deadlines are likely to stimulate a repeat performance of the debt ceiling negotiation that took place July and August of 2011. Given that Sequestration is not capturing public attention, we expect Republicans and Democrats to become even less willing to compromise during the next round of budget discussions. Once again, we will see if the hand-wringing, finger pointing and doomsday forecasting of politicians in advance of March 27 will have any meaningful impact on the investment world.
With the credit markets firmly bullish, a “risk-on” trade going strong in small and mid-cap stocks and our market sentiment indicator in the mid 70% area, we expect stocks to continue to trend higher albeit with potentially higher volatility.
Review of Positions
TD Ameritrade (AMTD) – Mar 1, we recommended to buy to open the AMTD Aug 22 Calls (AMTD 130817C000022000) for $0.40 or less. As of Friday’s close, these options closed at $0.39.
EMC (EMC) – On Jan. 10, we recommended to buy to open the EMC April 25 calls (EMC 130420C000025000) for $0.95 or less. As of Friday’s close, these options closed at $0.19.
Healthcare Trust of America (HTA) – on Feb 13, we recommended you buy to open the HTA Jul 12.5 calls (HTA 130720C0000125000) for $0.45 or better. On Friday, this position closed at $0.40.
Lilly (Eli) & Co. (LLY) – On Jan. 9, we recommended to buy to open the LLY July 55 calls (LLY 130720C000055000) for $1.45 or less. As of Friday’s close, these options closed at $1.96.
Thomson Reuters (TRI) – On Jan 16, we opened a position in the TRI Jul 30 calls (TRI 130720C000030000) for $1.60 or less. As of Friday’s close, this position was $1.95. We continue to like this trade.
Parting Shot: Market Sentiment Indicator
Shown below is our MSI (blue line) superimposed on the equal weighted S&P 500 measured by the ETF (RSP). As a reminder, we are bullish on the market when the MSI is above the 50% market and bearish when it is below.
The scale for the MSI is on the left hand y-axis. The MSI has rolled down from the low 80% area to the mid 70% range. Having the MSI back down into the mid-70% level helps alleviate short-term overbought conditions and is a healthy development with many of the major indexes near all-time highs. We remain bullish.
Have a great week trading,
Nick Atkeson and Andrew Houghton
Big Money Options