The market collapses to U.S. credit downgrade

Questions and answers about the market's turmoil

By DANIEL WAGNER

Source

Global stock markets tumbled Monday on the first trading day since Standard & Poor's downgraded long-term U.S. debt. The Dow Jones industrial average plunged 634.76 points, the sixth-worst point less in its 112-year history. Investors are anxious about a weakening U.S. economy and a widening debt crisis in Europe.

Some analysts had worried that Treasury yields would surge after S&P's downgrade. That would happen if investors demanded higher returns to compensate for their risk.

The opposite happened. Treasury yields fell Monday to their lowest level of the year as investors sought a safe place for their cash. Their actions showed continued confidence in long-term U.S. debt.

Here are some questions and answers about the market's turmoil Monday:

Q: Why are stock prices plunging?

A: Stocks are considered risky, especially when the economy falters. When the economy is growing, companies can expand, hire and increase profits. A string of bad economic data has led many investors to worry that the economy will dip back into recession. If that happens, stocks would likely slide further. Investors already were growing fearful about the economy before S&P's announcement Friday night. Oil prices also are falling, a sign that traders expect the weak economy to reduce demand from consumers and businesses.

Q: If everyone is selling stocks, where's that money going?

A: Anywhere safe. Traders are plowing cash into investments that are seen as hedges against economic weakness. Gold prices streaked past $1,700 for the first time Monday. And the yields on debt issued by the U.S. Treasury fell as traders, money managers and overseas banks sought refuge from the market's wild swings. Bond yields fall as their prices rise.

Q: Why are Treasury prices rising? Didn't S&P just indicate that they are a riskier investment?

A: Investors remain confident that the Treasury will be able to pay its creditors, downgrade or not. And Treasurys are still the world standard for safe, stable investments that can be converted into cash easily. Other nations with AAA ratings have much smaller economies and issue much less debt. When investors seek safety, they don't have many options other than Treasurys.

Q: If the S&P downgrade isn't driving all this selling, why are markets plunging now? After all, the economic data was relatively encouraging on Thursday, when the Dow had its worst one-day point drop since 2008.

A: Things are looking grim in Europe. Central bankers there are trying to prevent Italy and Spain from becoming the latest nations to default on their debts. The European Central Bank on Monday is buying up bonds issued by those countries, to increase demand for them. A default by Spain or Italy would be disastrous for other nations that use the euro and could affect financial companies worldwide.

Q: Are investors more optimistic about overseas stock markets?

A: Not at all. Stocks around the world have taken a pounding. Even developing markets are vulnerable because of how U.S. and European weakness could reverberate globally.

Q: Does this mean the economy is headed for another recession?

A: It can't be ruled out. Analysts note that the stock market's dive will make people feel less wealthy and discourage some from buying new cars and homes. If enough people feel discouraged by their loss of wealth and cut back on purchases, fears of another recession could become self-fulfilling.

The market reacts to U.S. credit downgrade
The Chase by Marty Cej:

"I think S&P has demonstrated some spine; they finally got it right."
- Bill Gross, PIMCO founder and manager of the world's biggest bond fund, to Bloomberg News.

"We don't care what S&P thinks, about Treasuries or anything else. And we are completely baffled that anyone else would take it remotely seriously, either."
- Ian Shepherdson, chief U.S. economist at High Frequency Economics.

So many angles, so little time. Our immediate focus must be on the markets: bonds, currencies, stocks and commodities. The bond market will dictate the direction of stocks today as investors try to price in the impact of higher borrowing costs in the U.S. on economic growth and earnings. Most of our viewers view the health of the financial system through the prism of their own stock portfolios so we need to constantly connect the dots and answer the questions of how and why a downgrade to U.S. debt affects Canadian equities.

In the simplest terms, higher interest rates on U.S. bonds mean higher rates on any loans tied to Treasury securities, such as mortgages and car loans. Higher borrowing costs for U.S. consumers and companies mean slower growth, which in turn means less demand for goods and services. But will this downgrade from S&P necessarily lead to higher rates? In a note to clients this weekend, the analysts at Strategas examined all the instances of downgrades from AAA over the past 25 years and found that in 10 of 11 cases, the local 10-year government bond yield was lower a year later. Governments, they argue, fight back when they are challenged. Barry Ritholtz has pointed out as well that Japanese stocks rallied more than 3 percent on the first day of trading after that country's debt was downgraded in 2001.

We need to pick apart the impact of the debt downgrade on stock sectors including the financials, resources, consumer discretionary and technology. Did I mention the financials? That includes the banks, insurers and money managers.

Glancing away from the stock market for a moment, we'll need to talk about what it means for the Canadian bond market now that we are one of the few AAA credit ratings left out there that can still field a competitive hockey team. A quick look at the screens shows the yield on the 10-year Canadian bond soaring 14 basis points to 2.63 percent. What gives? Just as the downgrade to U.S. debt will have knock-on implications for state and municipal debt as well as the debt on U.S. government-related entities, there will be knock-on affects for Canadian provincial, municipal and corporate debt.

And what about the ratings agencies themselves? Here's what PIMCO's Mohamed El-Erian had to say: "The future role of rating agencies will also now come under close scrutiny, bringing to the fore the question of who rates the rating agencies? S&P's action will likely unite governments in America and Europe in an effort to erode their monopoly power and operational influence. This will also force all investors to do something that they should have been doing for years: conduct their own ratings due diligence, rather than rely on outsiders." Has S&P bolstered its reputation or ruined it for good?

The G-7 said it will step in with a coordinate effort to stabilize financial markets with particular attention to the currency market and the ECB has stepped in to buy Italian and Spanish bonds – yields on 10-year debt are down 75 and 83 basis points respectively – so could today actually prove to be the inflection point in the rout that has lasted two weeks?

In commodities, gold is shining and oil is tumbling. Pork bellies – bacon, mmmmmm – wheat, sugar, copper… they're all down.

That's just for starters, and I haven't even touched on Europe.

Equedia Weekly Ivan Lo

In less than in a few weeks, more than $4.4 trillion was wiped off stock markets around the world. On Thursday, we had the biggest one day decline since October 2008.

The markets, the European crisis, and the political battles are wreaking havoc on our summer vacation.

Adding more fuel to the fire, the S&P just lowered their long-term sovereign credit rating on the United States of America to 'AA+' from 'AAA' and affirmed the 'A-1+' short-term rating. Let's not forget, this is the same S&P that gave triple-A ratings to some of Wall Street's riskiest packages of mortgage-backed securities and collateralized debt obligations that infused the crash of 2008.

Could things get any worse?

While I can't sit here and confidently predict day-to-day events given the political climate, I can't say I am surprised at what happened. For months I have been saying the markets are overvalued and that the US is in trouble - both long and short term. Does that mean the markets will continue to freefall?

The simple answer is no - the bottom for this summer drought appears to be forming.

P/E ratios are incredibly low and many stocks have now been battered so badly that even the mediocre ones seem like bargains. This isn't a repeat of 2008. There is tons of liquidity in the system and the economy is nowhere near as bad as 2008. By the end of the year, we will look back at summer and wished we had more cash to buy more stocks.

That doesn't mean you should go out there and dump everything you have into the markets. I continue to like gold, silver, and related stocks - especially over a longer period of time. However, we still don't know what politics and what Europe has in store for us. Will the downgrade make a difference in the markets? Will Bernanke implement QE3? Maybe, maybe not.

But if you remember during the debt ceiling debate, I said (see The Next Big Wave) the debt ceiling will be resolved in the eleventh hour, and it was. So while I can't tell you what's going to happen tomorrow, I can tell you confidently what I think will happen before the year is over.

Before I do that, I want to go back to a previous letter I wrote in June, titled, "Time to Feel the Pain." If you already read it, it's worth reading to refresh your memory. If you haven't, I suggest you do so.

In the meantime, here is a brief excerpt:

While there will be bargains, that also means the overall markets may still have further downward pressure. Especially when Federal Reserve Chairman Bernanke looks so defeated.

Last week (June 5, 2011) I said, "With all of the money spent through all of the US' loose fiscal policies, nothing has changed." On Tuesday, Bernanke reiterated those statements causing the markets to fall even further down south.

In his Tuesday speech, he said that seven months after the central bank began a historic round of monetary stimulus, growth in the broader economy has been disappointing. But with the amount of money printed and no real results, Big Ben has planned to stay on course, ending stimulus on schedule this month and keeping monetary policy steady for the immediate future.

Bernanke has finally admitted what we already know. The recovery has fallen short of the central bank's expectations by a number of different measures. Six out of ten leading indicators are bad and the other four appears to be getting worse: Unemployment is high, and anyone who has found work must accept lower wages than they previously earned. Home prices are falling at a newly accelerating rate (see The Greatest War in History), making homeowners more vulnerable to default and foreclosure. Manufacturing is down and oil is trading at levels reminiscent of 2008, when months of record-high fuel prices helped drag the economy into recession (combine that with OPEC's recent objection of raising supply.) All obvious points that I have mentioned in previous letters.

The central bank's ability to boost the economy, or its willingness to attempt to do so, has reached a limit. Or has it? Was the amount of money being spent really used to bolster the economy or was it used to bolster the wallets of the Fed by lending as much money as possible to the world's most powerful nation?

Bernanke has made it clear that there will be no QE3...yet. But before we make any judgements, let's not forget that after QE1, he hinted there wouldn't be a need for QE2.

The truth is, the next QE, be called QE3 or something completely different, will eventually happen. But before it does, America will need to feel the pain. Without pain, there will be no political will.

That was written June 12, 2011. It is now August 7th. We're starting to feel the pain.

America, like it or not, will have to do something drastic to keep things moving. In an exclusive interview with the Wall Street Journal, Donald Kohn and Brian Madigan - the last two directors of the Fed's powerful monetary affairs division - said the Fed should consider a third round of bond purchases only if inflation slows from recent elevated levels and if the economy continues to underperform.

The signs Kohn and Madigan speak of are here. This recent flash crash has caused the perfect storm for implementing QE3. The economy is underperforming. Inflation is moderating - commodities prices have eased and measures of inflation expectations have retreated a bit recently. The stock market is getting crushed. The US has been downgraded. And investors are fleeing. We're feeling the pain.

While I think the S&P rating on US debt is a complete sham (Moody's and Fitch have maintained US' AAA rating), the markets may think differently. I go back to how ignorant a mob can become. Their panic selling will cause them to lose their shirts but it will also allow those who are calm to seize the opportunities.

I know next week can be scary but I don't think the downgrade will mean much to the market. If you believe in value, taking some more risk during this time could prove very rewarding - as it did for those who purchased stocks after the 2008 crash. I'd be a buyer on dips next week.

"Be fearful when others are greedy, and be greedywhen others are fearful" - Warren Buffett

This coming Tuesday, the Federal Open Market Committee will convene and Bernanke will speak. What he says will undoutedbly have an effect on the market, so be prepared. While he may hint at QE3, this may not neccesarily be enough to satisfy the battered and bruised investors. For the most part of August, we still need to be careful.

If next Tuesday fails to provide anything, the focus will quickly shift to August 26 for Bernanke's speech at the Jackson Hole, Wyoming Fed conference. And that's where I expect Bernanke to really pump up the markets, as he did last year with QE2.

If you remember on April 11, 2011, I wrote the letter, "Beware the April Fool":

Bernanke's statements have a major impact on the markets. Earlier in the week, the Dollar rallied simply because he told us that "inflation must be watched extremely closely." Imagine the consequences of an open press briefing.

In his August 27, 2010 speech at the Fed's Economic Symposium in Jackson Hole, Wyoming, Bernanke signalled the possibility of QE2 (Quantitative Easing 2):

"I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions,"- Ben Bernanke, Fed Chairman

A couple of months later in November, the central bank announced plans to purchase $600 billion in long-term Treasury securities by the end of June 2011.

The S&P 500 is up more than 25 percent since Bernanke's speech at Jackson Hole.

If historical political events are any indication of what's going to happen, expect Bernanke to hint at QE3 sooner than later. While it may not have as strong of an effect on the market as QE2, it should be more than enough to push the market into another short term rally. This will give us another opportunity to make some money and then begin our own selloff before May 2012.

The market mob has turned every investor into a day trader. If you're not a day trader, don't act like one.

Until next week,

Ivan Lo

Equedia Weekly