The unthinkable has finally become a reality: The U.S. government has shut down.
A legislative deadlock triggered by President Barack Obama's Affordable Care Act (aka Obamacare) combined with fears of a U.S. debt default has resulted in shivers of fears in the economy. Talk of economic Armageddon, crashing markets and mayhem has dominated the press over the past several weeks.
History makes it clear that the shutdown fears are unfounded. There have been 17 government shutdowns since 1976 with 21 days clocking in as the longest. The current shutdown makes 18.
While shutdowns are relatively common, the real worry is the pending U.S. sovereign debt default slated for Oct. 17. Although the definition of default is debatable, it is generally taken to mean that the United States can no longer pay all its bills.
As you can see, the U.S. has tremendous obligations. According to the Bipartisan Policy Center, on Oct. 17, the U.S. will have about 68% of the funds needed to pay its bills the following month.
Although this is a highly unusual situation for the United States, it has come close to happening in the past. In fact, some economists argue that the U.S. has defaulted on its obligations several times. This is due to the inexact definition of default.
No one really knows for certain what a U.S. debt default would do to the economy on a national or global scale. Guesses run the gambit from a Greece-style economic disaster to very little effect at all.
The good news is, all it takes is an agreement to increase the debt ceiling to avoid the situation altogether.
While it remains highly unlikely that the government will let a default occur, if it does, the value of U.S. bonds will likely plunge. This is due to the fact that U.S. bonds would be believed to more risky. The lower bond value would result in higher yields, thus worldwide interest rates will increase.
It's important to note that even Treasury Secretary Jack Lew has said he doesn't know what will happen should the default occur. While I firmly think that the default scenario will be averted, smart investors know ways to protect their capital should the unthinkable occur.
Here are four things that may happen should the U.S. default, and how you can profit.
|1. Plunging Stock Market|
|Nimble investors could make impressive profits by shorting the stock market prior to the default. Inverse exchange-traded funds (ETFs) such as ProShares Short S&P 500 (NYSE: SH) or the Direxion Small Cap Bear 3X Shares ETF (NYSE: TZA) make putting on a short-term short position an easy proposition. The good news is that lower stock prices mean higher dividend yields.
Income investors with capital to invest after a market plunge could earn shockingly high yields due to the lower stock price. In addition, a stock market plunge will provide brave investors a powerful, perhaps once-in-a-lifetime opportunity to purchase stocks at vastly discounted prices.
Finally, option contracts known as puts can be purchased to protect your portfolio against a plunge. One put is purchased per every 100 shares that you own in specific companies; a hedge can also be built by purchasing puts on the SPDR S&P 500 ETF Trust (NYSE: SPY). Puts will enable you to lock in some of your yearly gains regardless of what happens in the stock market.
|2. Surging Gold Prices|
|Gold has long been thought of as a safe harbor against economic turmoil. The price of the precious metal should climb as hard-asset investors seek shelter from the pending U.S. default. Stock investors can anticipate a spike in gold's value by purchasing shares in the SPDR Gold Trust (NYSE: GLD) ETF.|
|3. Spiking Interest Rates|
|Interest rates will likely spike should the U.S. default become economic reality. Investors can take advantage of this situation by shorting Treasurys. That's not as complex as it sounds, thanks to the advent of inverse Treasury ETFs such as the ProShares Ultra Short 20+ Year Treasury ETF (NYSE: TBT).|
|4. Weak Dollar Benefiting Multi-National Corporations|
|A U.S. debt default will vastly weaken the U.S. dollar, which could produce favorable foreign exchange rates for multi-national corporations such as McDonald's (NYSE: MCD) and Danaher Corp. (NYSE: DHR). This is important to keep in mind regardless of U.S. default when choosing investments.|
Risks to Consider: It costs money to hedge your portfolio or prepare to profit should a U.S. default actually occur. In other words, protecting your portfolio isn't free. Therefore, investors need to weigh the odds of a U.S. default before making any changes.
Action to Take --> As with all investing, maintaining a diversified portfolio and having any excess capital ready to deploy into opportunities is the best way to approach the unlikely default. If it occurs, investors with capital will likely have an opportunity to purchase stocks at very depressed prices. However, if you are strongly convinced the default will occur, prudent and well-balanced hedging through put options and the options listed above makes good sense.