By now you have heard that ratings agency Standard & Poor’s downgraded the credit rating of the United States to AA+ from its vaunted AAA. Investors around the world seemed to take this opportunity and this moment to sell, sell, sell their equities. In fact, the Dow Jones Industrial Average closed down today 634.76 points, or a 5.55% loss. Similarly, the Standard & Poor’s 500 Index fell 79.92 points, or 6.66%.
From multiple perspectives this sell off looks over done to me. Here’s why:
- U.S. government debt actually traded up on the day, such that yields actually fell. This clearly makes no sense since a credit rating cut on this very same debt means that it is riskier and therefore less valuable; so yields should have gone up. Presumably there was a flight out of “risky” assets, like stocks, into safe assets, like U.S. government debt. Frankly, this is retarded and clearly so.
- There are U.S. companies that retain a AAA credit rating – higher than that of the United States government’s sovereign debt – all of whose shares traded down today. Again, if this was some sort of “flight to quality” then why wouldn’t these shares have logically traded higher? Instead, the shares of these businesses were caught up in gigantic sales of things like S&P 500 futures, SPDRS, index funds, or just general panic selling.
- Most U.S. businesses, the folks that issue those shares of stock that sold off today, did not have their risk profiles change because the U.S. government debt sold off. You can make the argument that the equity risk premium, the amount of extra return that stocks have to provide in order to induce you to take on additional risk beyond that of a bond, has increased. The thinking here is that the cost of equity is composed of: risk free interest rate + equity risk premium + specific risk of a company. The part of that equation that changed was the, now obviously incorrectly named, “risk free rate.” This rate was always taken to be the yield on a 10-year U.S. Treasury Note. Yet that risk free rate actually fell today. Not only that, but the stock market fell by 6.6% today; presumably because all U.S. equities became 6.6% riskier today. But did U.S. businesses really become 6.6% riskier all in one day? Clearly not.
- As of Friday the S&P 500 Index had a total market capitalization of $10,950.54 billion, or basically $11 trillion. For those that don’t know “market capitalization” means the total equity value of the 500 companies that make up the index. That the S&P 500 fell today by 6.6% means that U.S. businesses are worth $722.735 billion less than on Friday. By comparison the yield for a 10-year AAA credit is 2.39% as of Friday, whereas the yield for a 10-year AA+ is 2.50%. The difference between these two, or 0.11%, is a proxy for the interest rate increase that the United States will experience because of its new credit rating. The United States has approximately $14 trillion of debt outstanding. So the interest cost on that debt went up on Friday by $15.4 billion annually. Look at the differences in the sell of of U.S. equities – $722.735 billion – vs. the increased interest costs on U.S. debt at AA+ – $14.5 billion. This would seem to suggest an equity sell off that is 46.9x larger than it should have been.
- Only S&P downgraded U.S. debt while Moody’s and Fitch, the other two major credit ratings agencies, held the U.S. at its AAA rating. So the composite rating of the U.S. is still AAA. Furthermore, S&P only followed through on its credit ratings warnings first described in March. In other words, there was plenty of time for financial market participants to absorb and assess the potential effects of any downgrade.
- The downgrade should trigger action by politicians to figure out a way to shore up the current and future finances of the United States. When will Republicans agree that taxes are too low and consequently to a tax increase, for example? Or at least the closing of massive loopholes that allow U.S. corporations to effectively pay 0-5% in corporate income taxes.
At an intuitive level there is tremendous amounts of queasiness in the system, so the capitulation that I described as needing to happen has yet to occur. Trust me folks, when the queasiness subsides it will likely be one of the best buying opportunities since 2009. Why? U.S. businesses remain in fairly good shape, unlike in the lead up to the Great Recession. Right now panic is being driven by the finances of the U.S. government which is a much smaller percentage of the U.S. economy.
Jason
[This post has been edited for typos, but not for content.]
Hello again Jason,
Forgive me if I misread your analysis, but your reasoning and conclusions appear to be based entirely on the assumption that the S&P downgrade and the market’s overreaction to it were the major reasons for the selling. When calculations yield retarded answers you should first check your math then check your model assumptions.
I can think of a few other plausible reasons for a sell-off that have little to do with the downgrade. Some examples include: (1) continuing fears over the Eurozone crisis; (2) downward revisions made to future U.S. GDP projections (during last week); (3) perceived economic implications of the debt deal; (4) worries about the mounting law-suits against Bank of America over its handling of mortgages and foreclosures; (5) group think, general market mood, and sudden realization that the stock market was overvalued.
I vote for all of the above in some combination. I imagine that for many investors, a weekend was needed to digest the numerous events of last week in order to formulate a determined response. Neither today’s nor Thursday’s sell-offs seem like panics to me; they seem more like a return to sobriety.
P.S. I have noticed that the “Notify me of followup comments via e-mail” option does not work on this blog.
Hi Stephen.
Thank you for your comment, Stephen – as always, they are appreciated, as is your loyalty to the blog.
Regarding the causes/sources of the “sell off” as described by you: I have to retort a very mild, “well duh!” As you know from reading the blog as aggressively as you do, each of the factors you described as contributing to a 8 August, 2011 sell off have been talked about by me and, in most cases, for multiple years. These factors are not an oversight on my part. I wanted to highlight the absurdity of the selling yesterday relative to the only new piece of actual news: the downgrading of the U.S. government by S&P.
In your comment you ascribe a certain logic to the selling; implicit in this is some sort of assumption that investors are rational actors, or some variation of the “efficient market hypothesis.” I am basing this assertion on your numbers (1) through (4) which all ascribe some sort of logical reasons for the selling of Monday, 8 August. Frankly, I just have never experienced investors, professional, semi-professional, amateur, experienced or inexperienced as being rational, in the aggregate. So of your points the one that makes the most sense to me is “(5) group think, general market mood, and sudden realization that the stock market was overvalued.” Which is why I highlighted in my post the true absurdity of the selling Monday. But let’s adjust the absurdity scale from the amount of additional interest expense to be paid by the United states that I highlighted in yesterday’s post to something that should clearly illustrate for you the silliness of the magnitude of the sell off.
Most important in the enumeration of this post is the ~$722 billion difference in equity value ascribed by investors yesterday relative to the close on 5 August, 2011. That is equivalent to a decline in market cap of approximately 5.0% of 2010 of gross domestic product (GDP), or $722.735 billion divided by $14,418.16 billion. Meanwhile the total lost GDP in the Great Recession was just $353.5 billion, or peak ’08 GDP of $14,291.5 billion – trough ’09 GDP of $13,939.0 billion (source: U.S. Department of Commerce). So yesterday’s sell off destroyed, in wealth, double what was actually lost economically in the greatest post war economic decline.
What’s more, the cumulative plunge of the S&P 500 now stands at 17.3% dating back to the most recent peak of 7 July, 2011, or 1,119.46 (close 8-8-2011) divided by 1,353.22 (close of 7-7-2011). That 17.3% plunge represents a loss of market cap of ~$2,134.27 billion, or almost 7x the amount of lost economic flow in the Great Recession.
Regarding the “Notify me of followup comments via e-mail” option – I will look into it.
Keep your comments coming!
Jason