Breakout

After S&P Downgrade, ‘Sunday Night, Pray’ and Other Thoughts From Traders

Breakout

Standard & Poor's decision to downgrade the U.S. on Friday from what was once believed to be an eternal AAA rating has for many observers been an academic undertaking. Not for professional traders.

They've got to make a living, and that means turning this into a money-making opportunity -- or at least a time to preserve precious capital. They still have a few hours before the markets start truly revealing how they're going to be influenced by S&P's decision to cut the world's biggest economy by one step to a AA+ rating. Comments from people who trade professionally make it clear that the downgrade shouldn't have been a tremendous surprise, even if the timing might have been. But now that's it's done, it's time to get properly positioned.

So what should we expect to see when Monday arrives? Some traders who haven't already unloaded shares may look for opportunities to do so, and that may worsen what could be already volatile trading with dramatic swings. Soothing words from the Federal Reserve may be coming soon. In short, we don't know for sure.

Much of the talk in the immediate aftermath of the downgrade has been on its negative aspects, but for those on Wall Street, S&P's move actually removes an overhang from the market. And the market, as we should all know by now, despises uncertainty. What's done is done, and now we move on.

Critical Days

Scott Redler, chief strategic officer of T3Live.com, expected S&P to move a little sooner. Now that it has, the downgrade has woken everybody up.

"We deserved it," he says, an opinion not unlike that of Breakout's own Jeff Macke. "The way Washington handled the [debt-ceiling compromise] made the U.S. look horrendous on the world stage."

Though the market felt a downgrade was coming, Redler isn't sure the reality of it is fully reflected in current valuations. Regardless, it's now in the rear-view mirror, and for the pros that's no small thing.

"I'm glad it's out of the way, and now I'll see how the market's going to respond to it," he said in a telephone interview Saturday.

Monday and Tuesday, he says, will be "very critical," because if the market can absorb the first downgrade in U.S. history, that would create confidence -- but that still has to be seen.

Hit to Housing

Hilary Kramer, founder of GameChangerStocks and a veteran trader, says the equity market figured S&P was about to act.

"The debt 'debate' and political discord, combined with Italy and Greece's immediate liquidity crises, weren't enough to cause a 7% loss this week," she said in an email. "Fundamentally, we knew something was brewing," with word spreading that meetings were taking place at the Treasury Department and the White House.

Kramer says even with Moody's and Fitch maintaining their highest ratings on the U.S., some funds globally might diversify away from American debt, and borrowing costs could conceivably increase. "The biggest hit will be to the housing market that's on life support," she says.

As for Monday, Kramer plans to look for buys, particularly high-beta stocks, meaning those that have the potential to drop the most and then bounce up the sharpest. Google (GOOG) and Apple (AAPL) call options, she said, would be on her radar, as will Caterpillar (CAT) calls.

For the individual investor, she says the early part of the week should be seen as a buying opportunity, with the exception of the housing sector. That's because she's not going to be shocked to see an initial sell-off, which she expects to bring out reassurances from President Obama and Federal Reserve Chairman Ben Bernanke (the Fed's policymaking Federal Open Market Committee meets Tuesday).

Favoring Clarity

Money manager Stephen Eubanks of Eubiquity Capital and MrTopstep.com, believes the cut isn't going to be favorable for the bulls or the holders of U.S. debt.

"The reaction from governments, both domestic and foreign, as well as major investors, should be seen very quickly in the markets," he says in an email exchange. "If there is one thing investors/traders don't like, [it] is trading through a fog -- traders favor clarity."

Traders have already been looking to limit their risk, and Eubanks says the markets have accounted, to at least some degree, for threats, such as softening economic data, the possibility of a double-dip recession and the wobbliness of the eurozone.

Danny Riley, Eubanks' MrTopstep colleague and an S&P futures trader who has been trading since the late 1970s, says the inability of the major political parties to work together puts both at fault.

"Had they been decisive early on, even if S&P didn't like the agreement, things could have been different," he says via email. "But all the back and forth, right up until the last minute, left the S&P with no choice."

Riley believes the cut will set off a chain of negative events and that the public would be wise to avoid the markets. "Don't trade," he says, adding an exclamation point. "The reason is the retail accounts don't have enough cash, and one bad trade can wipe out their accounts."

So what's next? Three options, he notes: Liquidate positions, hold your ground or wait for a larger decline that will open up entry points for long positions.

"This will be no different than any other day for us, but we suspect that several hedge funds will be reporting problems, along with margin problems at many of the CME's firms," he says. "Just because the stock market/S&P has sold off 160 [points] in the last 10 days does not mean that the markets won't be down sharply. They will be."

Riley has considerable experience, which is particularly valuable at times of outsized uncertainty. Back in 2008, he says, he was arguing that it would be 10 to 15 years before the effects of the credit crisis had been removed from the market.

"Does it mean the U.S. is no longer a good place to invest?," he asks. "No, the U.S. is still the No. 1 stock market in the world. Let the market fall into September, and then look for a big year-end rally."

'Sunday Night, Pray'

Simon Baker, the chief executive of Baker Avenue Asset Management, says he's been completely in cash since the middle of June, when his firm's market sentiment indicators went negative and volatility began to rise sharply.

For Baker Avenue, it won't be a quiet weekend, he explains via email. "We have a special investment committee meeting Sunday afternoon to review all strategies and possible scenarios on Monday," he says, followed by, "Sunday night, pray."

Baker was factoring in about 80% odds that S&P would downgrade the U.S. after its prior warnings and after the debt-ceiling outcome in Washington failed to meet the agency's liking. "We do not think [the downgrade is] aggressive," he says. "Controversial, certainly."

Heading into the week, Baker isn't going to be surprised to see a notable sell-off, but one that would create the conditions to jump back in and buy large-capitalization stocks that have been sold down too far.

"We call these deeply oversold markets a 'blue buy,'" he says. "They have only occurred six times over the past five years and are historically great entry points back into equities."

This is important, because asked whether individual investors should be concerned, he responds: "Yes, very-- if they have a buy and hold strategy."

On the upside, a positive of the downgrade could be that lawmakers in the nation's capital will strive to find greater deficit-cutting measures, he says.

How Is It Different?

J.C. Parets, a market technician who runs the site All Star Charts and who has been trading professionally for over 10 years, is driven more by what the charts reveal than by the news, and he's expecting volatility in futures on Sunday night and in the premarket Monday. But like others in the field, he wasn't caught off guard by the downgrade.

"To think this wasn't coming would be somewhat naïve," he says."Rumors were all over Twitter throughout the day Friday. The timing was interesting -- Friday after the bell, when most traders were in a different place mentally. Like when companies report bad news after the bell Friday, thinking that people will forget by the time Monday rolls around."

As for the start of the week, Parets says observing the bond market is crucial.

"We saw a monster rally in Treasuries this week as stocks sold off," he noted in an email. "That negative correlation is important to watch." (For a visual, take a look at the chart he provided.) "There is obvious resistance here around 105. At these extreme overbought levels, a continued sell-off in T-bonds would be positive for stocks (like it was Friday). Treasury yields of course had a nice reversal of fortune on Friday after getting killed over the last week. Higher yields (for riskier bonds now by definition) are positive for stocks here."

And he offers this for retail traders -- something to keep in mind and hopefully be instructive.

"Individual investors should be used to being concerned by now," he says. "Why is today different than a year ago, three years ago, 10 years ago? The structural bear market in equities that we have been in since the turn of the century has not ended. The cyclical rallies that we have seen have been tremendous trading opportunities, but the major down cycle here is not over. Typically, they last 14 to 18 years."

What that means, in short, is be nimble, and be ready to act fast. Direction isn't important. Staying solvent is.

'Teasing the Dragon'

For Jon Najarian, a 25-year options trader in Chicago and co-founder of optionMONSTER, pricing in the market's reaction to any event, known or unknown, is an inexact science.

"A week ago most of us thought the compromise on the debt ceiling would make for a decent rally, followed by a quick sell-off," he says. "But few of us foresaw the combination of horrible ISM numbers, exploding contagion fears in Europe and [an] imminent downgrade by one or more of the ratings agencies would all be thrown at the markets in unison."

Najarian, a CNBC contributor and frequent market commentator, noted that he has for several weeks been planning for a downgrade, expecting that it was not a matter of if, but when.

Past examples of the highest-rated sovereign debt being lowered show it's not the end of the world, he says, but if the rationale behind the cuts isn't addressed, a nation's borrowing costs can rise. For instance, he points out that Belgium, Italy and Spain lost AAA status in the late 1990s, but that a week after the fact, rates had barely moved and in some cases actually dropped.

"When we were working on the atomic bomb, physicists used low-level simulations of a bomb test, in which a sudden pulse of nuclear energy was initiated, sufficient to cause parts of the test assembly to jump apart momentarily (and occasionally to destroy the experimenter, but not quite enough to destroy the apparatus and its surroundings)," he says. "This became known as 'teasing the dragon,' with the obvious implication that there could be severe consequences to such experiments.

"Rhetoric about default had ramped up on a daily basis for the two weeks that preceded the agreement to raise the debt ceiling. I believe this was the president and members of Congress 'teasing the dragon,' calling focus onto U.S. fiscal folly in an overt attempt to scare lawmakers and their constituents into cutting a deal. As we observed from the market reaction Monday last week, that deal was little more than smoke and mirrors that investors easily saw right through."

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