Breakout

Don’t Blame the Downgrade: Macke

Jeff Macke
Breakout

Monday Morning Update:

Stocks are getting slammed, supposedly in response to Standard & Poor's downgrade of the US credit rating from AAA to AA+. But S&P's downgrade isn't the actual reason for the sell-off. As discussed below in a column written Saturday morning, the downgrade will have some sort of "knock-on" impact of unknown size, but by no accounts will S&P's decision in itself lead to collapsing credit markets around the globe.

Government officials are protesting S&P's move, pointing out the slip-shop nature of the ratings agency's work. Our Treasury Secretary Tim Geithner says S&P is "showing a stunning lack of knowledge." Others are pointing out that it takes a good deal of gall for any ratings agency to criticize the government as the agencies' complicity in the housing bubble of 2008. The NY Times' Paul Krugman goes so far as to compare the S&P to a "young man who kills his parents then pleads for mercy because he's an orphan."

Leaving aside how wildly inappropriate comparing a ratings agency to a sociopath is, the degree to which whining commentary misses the point is stunning. The market sets rates, not S&P. Markets aren't heading lower because of something S&P did. Markets are selling hard because of a lack of effective leadership in Washington and absence of leadership of any sort in Europe.

Whatever you think of the government's response to the crisis of 2008 and 2009, decisive action was in fact taken. The response of the Fed and other DC powers that be delayed, if not averted a complete economic collapse. The European financial system is collapsing country by country, rather than bank by bank, and there is no central system of governance with sufficient authority to stop it. One of the first things I said on Breakout when we debuted in March was, "the disappearance of the Euro as currency is going to seem incredibly obvious in retrospect." Suffice it to say, I haven't become less convinced of the Euro's demise in the last 6-months.

All of which is an argument for a different day. In the here and now, stocks are getting crushed and there aren't yet signs of the selling abating. S&P "support" at 1,250 held for exactly one day. The next technical level is somewhere in the vicinity of 1,140. That's our field position.

I'm not in the advice business. I'm in the business of arming investors with knowledge to help them think for themselves when protecting their portfolios. Here are some thoughts and insight into what I'm doing to helping you make your own decisions:

* Don't be oblivious but don't panic. Manage your money, don't let the market manage it for you. Know what your portfolio is doing. Ignoring your money makes it go away.

* Cash is a delightful place to be at the moment. The US dollar may lose its status as the world's reserve currency, killing the greenback, but it's not going to happen today. If you have cash in your portfolio don't be in a huge rush to put it work in stocks. I've been underweight in stocks since the market failed to break over 1,340 in May. I'm putting my cash to work s-l-o-w-l-y; 5% at a time and all in blue chips.

* Gold is gapping higher. Of course I wish I hadn't sold my gold ETF (GLD) last week. No, I'm not planning to chase the GLD higher.

* Listen to gurus but decide for yourself. Talking heads will be screaming advice at you today. Don't do anything they say simply because they seem credible and were right during the last crash. Yes, that includes me. I'm here to help, not run your portfolio.

* Sell until you can sleep. No, that's not the same as panicking. It's the opposite. If your portfolio is keeping you up at night, then your body is already panicking. Stop your panic by whatever non-narcotic based means necessary.

* Stocks can go lower than you think. That's what emotional selling means. Stocks plunge below any rational fair value (read: 666 is March of 2009) specifically because of supply from panicked sellers. Don't let your stocks be part of that supply.

* Yes, it's bad. But no, the world isn't ending. Hug your kids, take a little walk, and be glad you don't live in Greece.

More of my initial downgrade reaction is below.

S&P downgraded the U.S. credit rating from AAA to AA+ on Friday evening. The move was controversial, unprecedented and newsworthy to the point that it made the cover of even the non-financial press. The headline on the cover of today's NY Post blares "Debt Bomb."

The Financial Times is calling the downgrade "a contentious and historic move that highlights the weakened fiscal stature of the world's most powerful country." The key word there is "highlights." Which is humiliating but hard to argue. Make no mistake: The U.S. more than earned this downgrade. The nation is absurdly debt-laden and shows absolutely no signs of stopping.

The most galling aspect of the downgrade is that the final straw was the debacle of a debt-ceiling debate. Yesterday I said DC's lugubrious drama and resulting fake solution made up the most financially damaging fake crisis since LBJ's "Gulf of Tonkin" incident escalated the Vietnam War. S&P was nice enough to more or less confirm the point in comments made to the Financial Times. "The political discourse has diminished the credit standing of the United States," said John Chambers, the man who essentially made the final call.

Increased government spending at this point was a foregone conclusion, no matter what either side was saying. The country is in a recession (at least as far as I'm concerned; the National Bureau of Economic Research will make the official call in about six months, but why wait?). Stimulus is the only solution we know for a slow economy and was obviously what Washington was going to do. The problem for financial markets is less the spending itself and more the fact that the spending isn't actually stimulative at all.

Our GDP is under 2%, our unemployment rate is over 9% and both numbers are likely much worse than advertised. Our nation turned our desperate eyes to Washington, looking for grownups who could give us hope. Austerity, stimulus, a jobs program, corporate hiring breaks … just a different strategy of some sort. What we got was a batch of simpletons and whiners working the mic like bad professional wrestlers for two weeks before giving us a faux solution at the 11th hour. It was actually worse than professional wrestling; at least The Rock would have given us better rants.

During the Great Depression, FDR had a policy of trying almost anything and seeing what worked. If a plan seemed to stimulate, he kept it. If it didn't, he scrapped the idea and moved on to something else. Nothing except WWII snapped us out of the Depression, but there's a reason Roosevelt kept getting elected; at least the man didn't keep pouring more resources into solutions which obviously didn't work.

Breakout has been telling you the downgrade was a done deal for more than a week . We've been telling you how traders have been pricing in a downgrade. We've called it looming. We reported on the stock market chattering about this downgrade yesterday. I laid out the winners and losers on the fake deal last Monday.

What I'm saying is the downgrade was both deserved and anticipated. Looking ahead, here's what you need to watch and know:

  • Stock Market Reaction: From where I'm sitting, stocks have been pricing this in for a week and half. It's no surprise the selling started at roughly the same time as the ratings agencies started threatening the downgrade. The chatter of a downgrade on Friday was met with a brief, albeit frightening, sell-off of a few hundred points. That seems the most likely response here. Another "Black Monday" shouldn't result from S&P stating the obvious.
  • Debt Market Reaction: This is where the potential problem lies. All debt is priced based off the "risk free" rate paid by the U.S. government. Our government paid the lowest rates; everyone else from municipalities to corporations paid a higher rate based off how much riskier they were than the U.S. as a whole. Now that the US is deemed less than risk free, it's unclear how much higher the cost of money will be for everyone else. In other words, no one knows for sure how big the knock-on effect will be.

Note that the yield on corporate debt from blue chip to junk is nearly as low as it's ever been. Also note that Treasuries are paying historically low rates; in fact, so low that buying the 2-year actually costs you money if you include even modest inflation in the calculation.

Also remember that no rational person on earth was unaware that the state of the United States financial system was not as pristine as a AAA rating implies. The question wasn't whether or not a downgrade was deserved but if the ratings agencies had the guts to cut the AAA for the first time in history. S&P walked the talk, Moody's folded like a cheap tent in the wind. Make of it what you will, but you can't say we couldn't see this coming. There's cause to be concerned about rates across the board moving higher, but there's room for it to happen without triggering an economic crisis.

The Federal Reserve has already announced it will continue to accept Treasuries as collateral. In English, this means the Fed isn't going to force a margin call. That's good news.

Your bottom line is that you can weep for what the U.S. has become but you don't need to flee from Treasuries or blue chip debt based on the actions of Standard & Poor's. The agency did the right thing and deserves a huge amount of credit for having done so. In effect, this move just means S&P gets the very same credit they just took from the United States.

It's a butt-kicking our country richly deserves.

View Comments (244)