The U.S. Debt Hits The Ceiling, The Market Has Not.

Current Technical Setup

S&P 500 ETF (SPY) has been on a downtrend for the whole of 2022. Recently, there are signs of a possible recovery. I wrote an article in Nov 2022 about why I think the market might be near a recovery. Since then, the price action of SPY has not made a lower low, although it has retraced significantly before bouncing back above the 50-moving average (“MA”) (blue line).

Still, it is right below the 200MA (red line) which has proven to be a very strong (down trending) resistance.

In a more recent article that I wrote this year, I described in detail why I think there is a 40% chance of the economy heading into a recession. In my opinion, I still think this probability is significant but not overwhelming.

Overall, I am still optimistic that the market has bottomed and is likely to head for a bullish recovery.

Future Technical Outlook

In my opinion, the most recent price action of SPY has provided a few major signals that suggest a stronger likelihood of a market recovery. If we look at the chart in the previous section:

• Price has closed with a strong bullish candle after a significantly bullish ‘Golden Cross‘ of the 50 and 150MA.
• The last 3 candles (starting from 20 Jan 2023), form a bullish Morningstar candlestick price pattern.

To understand how significant the 50-150 MA crossover is in signaling the onset of a bullish recovery, we can back-test it over the last 20 years.

Specifically, we are looking for the following confluence of signals that occurred over the last 20 years after a prolonged period of being in a downtrend:

50MA crossed above the 150MA and both MAs either flatten or are visually observed to be slopping up.

From these charts, we can observe the above signals have successfully predicted the recovery of SPY over the last 8 major retracements.

Once again, SPY has closed above the 50-150 MA crossover with both of these MAs slopping up:

The price action even closed with a bullish Morningstar pattern. In my opinion, these are very strong indications that the market is on track for a full recovery.

Falling US Dollar

The US dollar has been rising steadily for much of 2022.

A rising USD might be good for US consumers who are able to spend more in foreign markets, especially when traveling abroad but it erodes the earnings of US companies that derived much of their revenue from these foreign markets. As described in an article by Deutsche Welle:

About 30% of US companies’ earnings come from outside the country, so many American exporters and companies with an international presence are feeling the pinch from declining foreign demand.

This foreign currency headwind (due to the rising USD) has significantly hurt the earnings of US big techs. Since the top 10 largest constituents of the SPY ETF are made up of the big techs, a fall in USD is expected to significantly improve the overall earnings of the SPY.

These headwinds look likely to change. Looking at the chart of the US Dollar Index (DXY), it has retraced below the 200-day average, indicating a significant weakening of the USD:

If this down-trending USD continues, we expect companies in the SPY holdings to progressively report more favorable earnings to drive up the overall earnings of the SPY. The price action should also reflect these improved earnings eventually.

Political Risk Of US Gridlock On Raising The Debt Ceiling

On 19 Jan 2023, the US government announced they have reached the $31.4 trillion borrowing limit. This results in the decision to undertake a suite of “extraordinary cash management measures”, which basically involves the suspension of investments in some government-related services that do not require immediate payment. These measures cannot be implemented indefinitely and will last only until 5 Jun 2023.

The US set a limit on how much the government can borrow in 1917, through the ‘Second Liberty Bond Act’ of 1917. However, this limit has always been raised since the Act was established.

This chart by Statista shows that in the last 40 years (since 1981), the debt ceiling has risen from less than $5 trillion to more than $30 trillion.

In my opinion, the risk of a US default by the U.S. government on its debt by not raising the debt ceiling is very low. As noted by Investopedia:

The debt ceiling was created during World War I in order to regulate U.S. government spending and to keep the U.S. government fiscally responsible. Since then, the debt ceiling has been raised or revised 78 times in order to avoid the possibility of default and keep the U.S. economy running, with no signs of Congress turning to other options, despite questions over the debt ceiling’s effectiveness.

While it may not be financially prudent to keep increasing the debt ceiling, with no other options to avoid a default, the US government is likely to raise the debt ceiling once again, as it has done so repeatedly since 1917.

With the USD being the global reserve currency, the US government has the capability to print more money to pay off its debt. What follows is the consequence of long-term inflation of the US economy due to the devaluation of the US dollar. In the long run, inflation is one of the reasons why the US markets always go up. Therefore, in the long run, long-term investors have nothing to worry about.

Still, when the decision to increase the debt ceiling is perceived to drag too long, it can result in significant (but not catastrophic) consequences.

For example, 2011 saw S&P downgrade US debt from AAA to AA for the following reason:

The downgrade reflects our opinion that the … plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.

Also, in 2013, US government shut down for 16 days, impacting the normal workings of some government infrastructural services.

Conclusion

Generally, the entire market has been on a downtrend for the past year. While inexperienced retail investors sell in panic, astute investors should perceive this as a great opportunity to buy stocks of fundamentally great companies on their watchlist.

Big Techs have already taken a beating in company earnings due to the unfavorable rising USD in much of 2022, but these headwinds are expected to cease as the dollar continues to fall, as discussed in the earlier sections. This will enrich investors who still believe in the future prospect of the Big Techs and are still holding on to their stocks.

The perceived macroeconomic headwinds of the rising US government debt ceiling are expected to result in the companies that derive revenue from government funding retracing the most. Such retracements are purely due to perceived macroeconomic risks which are expected to be temporary. Note that there is no change to these companies’ business fundamentals.

As such, this presents a great opportunity for long-term investors in these defensive companies like Boeing (BA), Lockheed Martin (LMT), and UnitedHealth (UNH).