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ETF Periscope: In Flux and Out of Time: Could Washington Really Blow Debt-Ceiling Deadline?

Posted on the 25 July 2011 by Phil's Stock World @philstockworld

Courtesy of Daniel Sckolnik, ETF Periscope

“Govern a great nation as you would cook a small fish. Do not overdo it.”  — Lao Tzu

ETF Periscope: In Flux and Out of Time: Could Washington Really Blow Debt-Ceiling Deadline?
The thing about playing the game chicken is that sometimes someone ends up getting flattened like a character out of one of those Saturday morning cartoons.

Make no mistake. The political wrangling inside the halls of Congress over the debt ceiling is nothing if not an extremely high stakes game of chicken. And, while almost everyone is certain that some sort of deal will be cut that allows the U.S. to stay open for business, it is not outside the realm of possibility that the shenanigans on both sides of the aisle could simply get out of hand, allowing the August 2nd deadline somehow to slip by.

That, as they say, could get seriously ugly.

Exactly how ugly is impossible to say, since a U.S. default on its credit obligations place us in uncharted waters. The range of predictions coming out of the pundit class ranges from small ripples in the national economy to huge waves of devastating economic turmoil on a global scale that would make the housing bubble of 2008 look relatively benign.

In any case, it seems like a reasonably prudent thing to avoid.

Interestingly enough, the consequences of the down-to-the-wire bargaining may impact the economy regardless of how the endgame gets played out. For instance, it seems that both of the dominant credit ratings agencies, Standard & Poor’s and Moody’s Investors Service, are threatening to downgrade the U.S. ratings a notch for even getting this close to the edge. Some cynics, however, are saying that both agencies are exhibiting tendencies of a rather malicious nature, perhaps in an effort to get back at Washington for daring to reprimand them for their role in the housing bubble, when they blithely doled out AAA ratings to some rancid tranches of “hell-bent-for-failure” mortgages.

In any event, premature downgrading seems, well, a bit premature.

Wall Street, which up until now has been more focused on the debt problems of the European Union far more than its own issues, will now be shifting its collective attention to problems at home, since Greece has just received its now-annual bailout. No doubt this very temporary fix to the EU’s debt crisis contributed to the Dow Jones Industrial Average (DJIA) having its single best day of the year. The Street’s generally good second quarter earnings reports also contributed to last week’s 2% rise in both the Dow and the benchmark S&P 500 Index (SPX).

But that was then, this is now.

Here are a couple of scenarios that can unfold in the coming week, one that will include a slew of economic reports and bellwether earnings announcements.

First off, Washington can “man up,” sign off on raising the debt ceiling, and focus on its next round of mischief. Coupled with some reasonably good earnings announcements from the retail sector, including Amazon, UPS, and Texas Instruments, there could follow a strong “relief rally,” and perhaps top the Dow’s high for 2011, which is a mere 120 points away.

The second scenario is markedly less pleasant. Should Washington continue to bicker deep into the week, Wall Street will get nervous and could show its displeasure with a selling of stocks. If the 2Q earnings reports are sour, and next week’s economic data confirms a stalled recovery, then the equity markets could come up with a serious case of skittishness, the volatility levels will skyrocket, and the markets will likely trend sharply downward.

Gold, an admitted safe-haven, would probably rise to even higher record-setting levels, with silver, at an unusually high ratio in relation to gold, hitching a ride northward as well.

So, if you’re on vacation and your portfolio is somewhat on the exposed side, be sure to slather on some “hedge-screen” so you don’t get burned. Just in case.

A relatively simple way to hedge your bets is to take advantage of the leverage that the VIX (Chicago Board Options Exchange Market Volatility Index) provides. The VIX, often referred to as the “fear-index,” frequently makes a significant move in response to major sentiment swings. When it goes up, it means volatility levels are up. When the VIX drops, it means volatility is down, generally reflected as a rise in the equity markets.

For ETF investors and traders, you can use VXX (S&P 500 VIX Short-Term Futures ETN). It tracks the S&P 500 VIX Short-Term Futures Index. Note that VXX doesn’t mirror the VIX precisely, but for the purpose of serving as a hedge, it can suffice.

ETF Periscope

Full disclosure:  The author does not personally hold any of the ETFs mentioned in this week’s “What the Periscope Sees.”

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