Downdraft and Downgrade

It was quite a week. We had just breathed a collective sign of relief after the debt ceiling compromise was reached, when the Dow Jones Industrial Average tumbled 512 points in one day based on fears surrounding the global economy. This was followed by the announcement late on Friday that Standard and Poor’s had downgraded the U.S. credit rating. While these are both unsettling events to say the least, neither should have been a surprise.

S&P had warned that they would downgrade our debt, yet our leaders failed to undertake the measures required to keep our AAA rating. More importantly, the deal struck by lawmakers does nothing to solve our real structural problems.

In one sense, we deserved this rebuke for failing to get our financial house in order – but it’s pretty hard to accept coming from S&P. This is the same company that gave their seal of approval to high-risk collateralized mortgage obligations just before they melted down along with the real estate market. I was particularly disturbed with the rationale given for the decision which was based on political considerations rather than economic reality.

Warren Buffet has spoken out to say that the action was unwarranted, and the other two major credit rating agencies have maintained the top rating for U.S. debt. There is no danger of the U.S. defaulting on its debt, so it makes no sense to lower the rating while maintaining the ratings of less deserving countries. I believe bond buyers will feel the same way and shrug off the action. Treasuries are the most liquid and secure debt obligations in the world and will remain so for the foreseeable future. The announcement is more symbolic than substantive as the U.S. dollar is still the world’s reserve currency and treasury bonds are still a safe haven during times of trouble. In fact, yields have recently declined (and prices have risen) despite all the negative news – which suggests that the market might know more than S&P.

I’m less sanguine about the prospects for the stock market – at least in the short-term. The stock market has been on a two-year upward trajectory since the low in May 2009. When the market rallies over 90%, it’s normal to have pullbacks along the way. It usually takes a catalyst to set a correction in motion. The debt ceiling debate brought a lot of bad news to the forefront, but our fiscal problems are not the only concern. Europe is in even worse shape than us, and fears of the Euro-zone debt crisis might have had an even greater impact on the market.

Investors should brace for another downdraft in the stock market even though the S&P announcement was delivered after the markets had closed on Friday to give people time to digest the news. Whereas the bond market seems to handle things in a more deliberative manner, there always seems to be enough traders, speculators and reactionaries to send the stock market plummeting at times like this.

Taking a longer view, economic fundamentals ultimately will determine the level of the stock market. Stock prices are almost perfectly correlated to earnings growth over the long run. While our local, state and federal governments are struggling – businesses are doing pretty well despite the slow economy. Corporate profits are strong and U.S. companies are competing well around the globe. Well balanced and globally diversified portfolios should withstand almost any economic conditions, including the challenging environment that lies ahead. I’m afraid the economy and job growth will remain sluggish for a while. Even so, I think patient long-term investors will be rewarded for staying with both equities and U.S. treasury bonds.

For investors who are contemplating bailing out of the stock and bond markets, I would ask this question. What’s the alternative? Almost any long-term investor needs exposure to stocks for growth and inflation protection, and bonds for income and security. Recent events don’t change this fundamental truth. Moving in and out is not a viable strategy, so it’s usually best to stick with your plan and wait out the storm. If you must do something, make sure that you have a target asset allocation that you can live with in good times and bad, and rebalance your accounts to the target allocation when they get out of line.