Market Update

In mid-July I wrote a market update and pointed out that despite all of the mounting economic and political pressures, most of the asset classes and strategies we follow were up for the year. That was July. August is another story.

August brought with it news that should have been considered good – a deal to extend the debt ceiling in the U.S. and actions by the Central Bank of Europe to stabilize financing in Spain and Italy. However, on the heels of that good news came the now infamous downgrade of U.S. sovereign debt by Standard & Poors, plus a renewed focus on the stagnant pace of economic growth in developed countries. In a matter of days, equity markets across the globe declined precipitously as some investors rushed to the exits, evidently fearing a replay of a Lehman-like contagion. Below is our take on the current situation.

 

The S&P Downgrade

 

U.S. sovereign debt has been awarded a AAA credit rating since it was first rated in 1917. Recently, all three major rating agencies have voiced concern about the ability of the U.S. to continue on it current fiscal path. On August 5th S&P lowered its rating on the debt of the United States one notch from AAA to AA+.

In many ways this rating change does not matter. Bond market participants will collectively assess risk and determine yields. Investors are relying less and less on the rating agencies, especially after their rubber stamping of sub-prime mortgage bonds leading up to the credit crisis. Nobel prize winning economist, Paul Krugman, sums it up nicely in a recent NY Times Op-Ed:

 

“It’s hard to think of anyone less qualified to pass judgment on America than the rating agencies. The people who rated subprime-backed securities are now declaring that they are the judges of fiscal policy? Really?”

 

Ironically, America’s borrowing costs have decreased in the short-term, as U.S. Treasuries benefited from a recent flight to quality. This is clear evidence that investors still perceive the U.S. as one of the most stable, resilient, and credit worthy economies of the world.

But in some ways the rating change does matter. S&P's rating methodology (a detailed explanation of which can be found here) contains a political assessment as one of five key factors. It is clear from S&P's commentary that the inability of our elected leaders to accomplish any meaningful fiscal reform played heavily into the downgrade decision.

 

All in all, the downgrade is a wake-up call – possibly the loudest yet – that now is the time to get our fiscal house in order.

 

The Market Reaction

 

The market activity of the last several days feels eerily like the fall of 2008 when equity markets fell faster and farther than many thought possible. The irony is that this decline is probably driven, in part, by investors who are running to the exits as fast as they can to avoid a repeat of the same. There are, however, some key differences between 2008 and 2011:

 

 

 

 

 

 

 

 

 

  • Equity markets are much cheaper now than in 2008 and valuation can provide a buffer on the downside.
  • Banks are better capitalized and operating with much lower leverage than 2008. The risk of a bank-driven liquidity crisis appears low.
  • Much of the bad news appears to be priced into the current market. There is an enormous amount of scrutiny being paid to global financial developments, unlike 2008 when the skeletons were mostly still in the closet.

 

 

Our response

 

When it comes to managing client portfolios there are many things we can do to foster long-term success in the face of inevitable market declines:

 

 

 

 

 

 

 

 

 

 

 

 

 

  • Make sure you hold enough in cash and stable bond funds to cover your short-term cash needs, so that we aren’t forced to sell at inopportune times.
  • Make sure that you have the right portfolio at the outset. Your investments should be in a diversified portfolio that reflects your tolerance for risk, and is designed to help you meet your family's long-term goals despite market gyrations.
  • Make the best of a bad situation. Stock market declines present opportunities. Today's environment offers opportunities in tax management and estate planning that can be proactively exploited.
  • Stay fully invested. If your plan is sound, then there is no reason to sell. It is human nature to want to sell at the very moment that one should be buying more. It is no coincidence that staying invested is sometimes the very hardest thing to do. The most profitable thing often is.
  • Participate fully in the eventual recovery. Of course, there are lessons to be learned, and tactical opportunities to be exploited, but the single greatest determinant to investment success is owning the market when it recovers.

 

Posted by Jay Healy at 7:15 AM
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