After a tumultuous week that saw the worst single-day stock declines since the panic of 2008-2009, S&P capped the experience by downgrading US Treasuries from AAA to AA+. S&P, of course, does not know anything that the market does not already know – that a dysfunctional political process will likely fail to deliver on the substantial revenue increases and spending cuts necessary to restore the United States to long-term fiscal stability. The fact that Moody’s – the other main debt rating agency – reaffirmed the US’s AAA rating earlier this week probably gave S&P the political cover to downgrade today. A split rating means that institutions will not be forced to sell or re-collateralize their holdings of Treasury bonds which was the only potential real negative impact from a rating change. Quoting S&P’s release, “The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.”
One might ask, in the year before a presidential election and with a split congress, whether any rational observer would expect the recent debt-ceiling deal to accomplish what S&P seemed to be expecting. Having destroyed their reputations and credibility by stating that select bits of the worst of the subprime garbage of 2005-2007 was as creditworthy as the one entity with the power to actually print dollars, they are now lurching in the opposite direction. According to S&P, Microsoft, an entity that either by regulatory fiat or competitive pressure could be bankrupt in ten years is now a safer credit than the US government. It is rather absurd, given the myriad of ways a government as creative as ours can cheat its creditors, to think that an actual default will occur. A worst case would instead see continued debasement of the dollar. If the US devalues its debt by resorting to the printing press, then it takes all dollar-denominated debt with it, so Microsoft’s AAA rating becomes meaningless.
Its no surprise that a federal budget process that ran record deficits in the midst of a credit-bubble fueled economic boom is totally unable to cope with the shortfalls in revenue and increased expenditures required in the recession and slow recovery that is the aftermath of the bubble. The silver lining is that the debate and pressure is being brought at a time where the problem can still be fixed and will likely spur real action by the electorate and government officals. US debt to GDP ratios, while high, remain manageable.
The equity markets have been volatile as a stream of bearish economic data was released over the past few weeks, with only Friday’s moderately good employment report providing some ray of hope that a slide into recession is not imminent. Despite this, American corporations remain highly profitable and flush with cash. Valuations are reasonable. A high quality, diversified portfolio with a dividend yield well above that of US Treasury bonds can easily be constructed today.
Moreover, the dividend yields on stocks grow with the economy and with inflation. Prices are volatile, but at current valuation levels, time will work in favor of patient capital. As we said back in 2008, long term buy and hold investing is the worst possible strategy, except for all the others that have been tried. Interestingly, the media is reporting that John Paulson, the hedge fund manager who returned over 400% by betting against the housing market in 2007, is down over 20% year to date (and that was before this week). It just goes to show that there are no magic bullets nor magic managers.
The future remains unpredictable and will continue to make fools of those who try to predict it. We reiterate that to know what you own and why you own it continues to be the only sane strategy for this seemingly crazy world we now live in.