Financial Markets Alert – August 7, 2011
Standard and Poor’s Downgrade of United States to AA+
Financial Market Impact

Dow Jones Industrial Average 11,444.61
West Texas Intermediate Crude Oil (barrel) 84.06
S&P 500 1,199.38

On Friday, August 5, Standard and Poor’s reduced its U.S. long term rating from AAA to AA+.  Despite an admitted miscalculation of nearly $2 trillion, S&P moved forward with the downgrade after financial markets had closed for the week.  Other rating agencies (Moody’s and Fitch) still rate the U.S. as AAA with a negative outlook.  Given the timing of the downgrade, the disregard for accurate analysis, and S&Ps eagerness to maintain relevancy, the downgrade has been met with massive skepticism.  Many believe that a rating agency that could not accurately rate mortgage back securities (S&P consistently rated the subprime mortgage debt AAA), or financial organizations (maintained investment grade ratings on Bear Stearns, Lehman Brothers, and Washington Mutual as they collapsed or entered bankruptcy) is not qualified to rate the most complicated economy on the planet.  With the downgrade, the United States now is rated identical to General Electric Capital Corporation and a notch higher than Wal Mart (current rating is AA).  The implication that the credit worthiness of a country that can print the global reserve currency is identical to a corporation that is subject to sales revenue is, at a minimum, incomprehensible.

The financial and economic conditions that existed prior to the downgrade remain the same even after the announcement by Standard and Poor’s.  As such, the downgrade is merely a commentary by one company on the United States budget process.  However, the action by S&P will impact volatility and short-term performance of stocks, bonds, and commodities.  Although the motivations for S&Ps downgrade may never be clear, it is important that financial market participants remain diligent, analytical, and even opportunistic as the downgrade is debated and digested.

A return to anything similar to the 2007 to 2009 fall in stock markets over the next few months is highly unlikely.  A very different financial situation exists today versus three years ago.  During the previous mortgage generated crisis jobs were rapidly being lost (currently the economy is adding jobs), corporate financial conditions were flimsy (today record amounts of cash exist on corporate balance sheets), and the stock market was far more expensive (12/31/07 S&P 500 price-to-earnings ratio was 16.9 times and as of 8/5/11 it was 13.13 times).

Most Likely Short-Term Market Effects of S&P Downgrade

  • Most financial markets will initially fall on Monday morning as uncertainty continues on the impact of the downgrade (On Sunday evening the Dow Jones Industrial futures are negative by approximately 200 points).   
  • Because rumors of the downgrade surfaced during the middle of last week, much of the decline has already occurred.
  • Ironically, U.S. Treasury debt may rally (interest rates decrease) as risk investors (equities and commodities) rush into the safe haven of government bonds.
  • Commodities such as oil may fall as market traders choose the “sidelines” as the downgrade to U.S. debt is modeled into global growth scenarios.
  • The positive effects will include cheaper gasoline and low mortgage rates.

Most Likely Long-Term Effect of S&P Downgrade

  • Although the effects of the downgrade cannot be known for certain, the outlook for stocks is not necessarily bad.
    • After Canada lost its AAA rating in 1993, the country’s stock market gained 15% in the following 12 months.
    • After Japan lost its AAA rating in 1998, Japanese stocks gained 25% over the next year.
  • After the “newness” subsides from the downgrade, securities will once again be valued on economic fundamentals (which appear to be improving).
    • New jobs created in July exceeded analyst’s estimates by 32,000 jobs (Bureau of Labor Statistics).
    • The Russell 1000 stock index has a price-to-earnings ratio of only 12.43 times and a dividend yield of 2.04% (Bloomberg LLP).
    • 80% of companies within the S&P 500 reporting 2nd quarter earnings exceed consensus estimates (Bloomberg LLP).
  • Interest rates will ultimately rise as investors require greater yields for lower rated bonds.
  • There may be improved bipartisanship to U.S. budget items in an effort to regain a AAA rating from S&P.

Our Approach

  • The direct exposure to U.S. Treasury securities for our clients is very small.  We do hold some United States Inflation Protection Securities individually and via mutual funds.  There are also some investments in U.S. Treasuries through bond funds.   We do not expect investors to experience a negative impact on these investments as a result of the downgrade.
  • We will continue to make investment decisions on elements highly correlated with investment returns (corporate earnings, employment rates, interest rates, and valuation multiples).
  • We will remain analytical and independent and execute strategies that have proven successful over time through both bull and bear market cycles.
  • Resist the pressure to make “knee-jerk” reactions to short-term, high volatility events.
  • Continue to deliver a buy low and sell high approach even during times when it may be in contrast to natural human emotions.
  • We believe that the relationship between the letter grade of a government and the investment prospects of individual stocks, funds, and bonds is mostly independent.
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