US Debt Downgraded

SeanInsights

Not surprisingly, Friday’s after market hours downgrade of the US long-term debt from AAA to AA roiled world markets today. Not that the downgrade was any terrible surprise — S&P had said as much: reduce the projected deficit by $4 trillion over 10 years or we’re downgrading, but I think the emotional shock was still painful. Essentially, this is just a recognition that 1) we need to reduce our long-term liabilities, many of which are Social Security and Medicare related, 2) bring our national spending in line with our receipts, and 3) get our political act together, which needs to happen in order for numbers 1 and 2 to happen.

The fundamental problem we’re having is not a US only-problem; it’s a worldwide mature economy problem — Japan, Europe, and the US are all in roughly the same boat: too many federal program liability costs, two wars (US mostly), and not enough taxpayers to support the burden. Add in a slowing economy, the lowest tax rates we’ve had in a long time, and reduced federal receipts as a result, and here we are. Even though all developed economies are having to deal with this issue (witness the goings on in Europe of late), for a variety of reasons — population growth, natural resources, a more open and innovative economy, and the dollar (still) being the world’s reserve currency — we as a country are probably better positioned to deal with this than most are.

So, then why the downgrade? The S&P downgrade probably reflects the politics of the situation more than the underlying economic issues. France, for example, has a debt burden and social commitments as large as or larger than ours, and yet they continue to enjoy an S&P AAA rating. The concern with respect to the US is that the two political parties, locked in an ideological battle of the wills, will not have the wisdom or fortitude to do what needs to be done to eventually resolve the long term issues. One can hope that the downgrade will ultimately and eventually serve as a wake-up call to our politicians, however focused they may be on the never-ending reelection cycle, to do what needs to be done. Time will tell, but markets sometime have a way of encouraging compromise on both sides of the aisle, as we saw with the TARP bailout bill in the Fall of 2008. By the way, Moody’s, one of the other big ratings agencies, reaffirmed the US’ AAA rating today (as did Warren Buffett, for what that’s worth).

With that background, here are a few thoughts on the matter, and on the market’s reaction:

  1. Five countries — Canada, Sweden, Denmark, Finland and Australia — have previously lost their AAA ratings, and then subsequently regained them. I suspect we eventually — when all is said and done — will make the difficult policy choices to regain ours as well, although that will take time. Although the Greeks have not managed to do so, that in and of itself is not a terrible surprise, as Greece has been in sovereign default for 105 of the last 200 years, and for our many faults, we are not Greece.
  2. The ratings agencies (S&P, Moody’s and Fitch’s) are all likely a bit twitchy right now. They completely blew it on the sub-prime mortgage bond ratings, which they almost uniformly rated as AAA, when they all should have been rated as junk. The agencies, therefore, along with others, bear some responsibility for the 2008 financial crisis, and as a result, are probably a little over-reactive right now. Thus — at least in part — Friday’s downgrade.
  3. As is usually the case, the market’s modus operandi is sell first, ask questions later, which in most cases, leads to short-to-intermediate term over-reactions. World markets were on tenterhooks over the weekend waiting to see what investor reaction would be, and I think a large number of people woke up with their finger on the sell key. So today’s market plunge, while painful to witness, wasn’t a complete surprise. As I wrote about in my piece on Wednesday, one day, even one week, market plunges don’t tell us much, if anything, about subsequent stock market performance, despite the tendency to assume they mean that more bad news (or more bad market performance) is just around the corner.
  4. Nothing makes this look like 2008 in my mind. Because so many banks were effectively insolvent, global capital flows came to a screeching halt in the fall of 2008 and this precipitated a very bad recession. If you had to point to two things that, more than anything else, could cause an economic meltdown, those two items would probably be: 1) the deflation of a housing bubble, and 2) the ensuing seizing up of capital markets. Both of those were front and center in 2008’s economic and market meltdown, and neither seems to in play here. The housing bubble has long since popped, although there may still be a little air escaping from the balloon, and banks and financial institutions are in infinitely better shape today than they were going into the 2008 crisis.
  5. Additionally, most US corporations — and probably most global corporations — are in much better shape than they were in 2007-2008. There remain record levels of cash on US corporate balance sheets, and this year — despite everything going on at the moment, and against even the most optimistic predictions of a year or two ago — US companies are on pace for record profits in 2011. Their share prices are also getting to be very cheap based on current and forward looking earnings, especially in comparison to the paltry rates most fixed income instruments are yielding at the moment.

And this brings me to why anyone would own stocks. Owning stocks is a bet on the long-term outlook for business, here in the US and abroad. It is not, and never should be, a bet on how business or stocks will do this year or next. As we sit right now, stocks are down 17% from their April peak, which is the same downward fluctuation that we saw in 2010. (Note I said fluctuation, not loss. It was only a “loss” for those who sold out sometime in 2010, thus locking in the loss). Surprisingly, we haven’t each reached “bear market” territory this year, which is a 20% broad market drop, and which happens every five years on average. We may yet see that (or may not), but remember, a 20% drop is about a once-in-every-five-year kind of event.

As I have said in many communications over the last year or two, EVERY one of my clients who had sold out early or late in the panic of 2008-2009 was worse off, financially at least, for having done so — some to the tune of hundreds of thousands of dollars — despite everything that ensued, including the worst stock market downturn since the 1930s.

In general, I believe stocks are likely to be the single best bet, bar none, for a long-term retirement plan, but only if you can own them, with all that that implies. What does NOT work is owning them when the sun is shining and selling them when skies are dark and stormy. That’s a recipe for peeling off ten thousand dollar bills, perhaps hundred thousand dollar bills, and lighting them on fire. Stocks will fluctuate, wildly sometime — as they did on the upside in the late 90’s, in 2003, and in 2009-2010, and on the downside as they did in 2008 and have done in the last week — but they also offer the best hope to participate in the long-term growth of the world economy and capture that growth for your retirement. Nothing, and I mean nothing, that Standard and Poors or the market does this week or year, is likely to change that fact. As Weston Wellington pointed out in the piece I sent out last Thursday about Indonesia’s poor debt quality but its very strong stock market performance, people are going to need soup, cell phones, oil, and everything else we buy and sell, from now until the end of time, and all of the companies of the world that make those things are going to do just fine . . . and so, I suspect, will the people who own those companies.

As always, I’d be happy to talk this over or answer any questions you may have, so please don’t hesitate to call or email.