*** We believe communicating with our clients is of utmost importance, especially during turbulent times in the market. While we don’t claim to have a crystal ball on the future of any financial market at a given point in time, we do believe that keeping clients informed on why things are happening increases their comfort level and understanding. This post contains a message initially sent to clients just after the S&P downgrade of the U.S. credit rating as part of that communication effort***

As you all know by now, S&P downgraded U.S. long-term debt from AAA to the next notch down, AA+ on Friday night. Before digging too far into that, I’d like to reflect back on what happened this week, one of the worst for the stock market since the Lehman Bankruptcy era, to make sure you understand why there are far bigger issues out there than one rating agency’s opinion of our debt repayment prospects. I apologize in advance for the length of this message, but I’d rather provide you with too much information which you can choose not to read than to leave you wondering about what’s going on.

On Monday of last week, we received the good news that the leaders of both parties in Congress had reached an agreement that would enable a majority of both the Senate and the House to pass a bill to raise the debt ceiling. The vote passed, the president signed the bill into law, and the crisis, if you believed there ever was one, was behind us. Markets initially rallied on the news as the general public had been told there was a chance of the end of the financial world stemming from a default on U.S. debt. When that chance disappeared, there was a lot of relief from those who believed it. Like I said in recent updates though, the debt ceiling was not a crisis, it was a political game using a completely irrelevant measure of how much debt we allow ourselves to have, rather than how much debt the market (i.e. our lenders) allows us to have. So, it didn’t take long for the markets to erase the “debt ceiling has been raised” gains and start to really worry about the banking system in Europe and the potential for a U.S. debt rating downgrade by the credit agencies.

First, a quick explanation of what’s going on in Europe. Several countries in Europe have taken on too much debt, well more than the U.S. as a % of their GDP (though our trajectory will have us catching up too soon to be comfortable about it). The markets have started fear that lending more money to those governments is too risky unless there’s a high interest rate to go along with the loan to account for the chance of not being paid back. The higher interest rates lead to more interest payments as a percentage of the tax revenue these countries collect which strains their budgets farther and requires more borrowing. More borrowing means even higher rates, and eventually there is no way out of debt and the only answer is default. Who owns most of Europe’s debts? Generally speaking, the banks in Europe do. The story from here should sound very familiar as it’s much the same as what happened during our mortgage meltdown that caused the same stress on the financial system. If the bank holds something that is starting to look worthless, it can become insolvent, it can fail, and depositors as wells as other banks that have lent it money can be left in the dust. In a way, it becomes self-fulfilling. The fear that the bank could become insolvent removes depositors and stops lending to that bank which can in turn make it insolvent (see the history of Bear Sterns and Lehman for a deeper dive into the process). So, to stop the rapid downward spiral in our case, our government got involved. They essentially provided the liquidity that the banks needed to reassure lenders and depositors they weren’t going out of business, while they raised money privately so that the government could be paid back. Most of you now know this campaign as TARP. The market is hoping that something similar can be pulled together in Europe to temporarily save the countries that are in jeopardy of defaulting on their debts. It’s more difficult there though, because each country has its own government, but they don’t have their own currency. It would take a huge amount of collaboration in good faith by the countries who don’t have debt problems, led by Germany, to rescue the other countries and prevent a banking collapse and a collapse of the Euro. In return for the effort, the debtor countries have to respond by agreeing to stop their over-spending ways and stop adding more debt… essentially providing a plan that will get them off life support over the medium term. The details over the possible coordinated efforts and the austerity measures would make this email longer than I imagine you want to read, so I’ll just leave it with this: if Europe as a whole doesn’t come to the rescue of the countries in Europe, then Europe as a whole is in for far worse than what we’ve seen from the mortgage meltdown. In a globally integrated world like we have, a depression in Europe would spread fairly quickly across the Atlantic and hit our companies and employment prospects very hard. Many don’t realize this but the European economy as a whole is even bigger than ours. Start to project a major haircut in their production and consumption and that is why the stock market plunged last week, with some areas down more than 25% from their highs less than a month ago, and the broad market down more than 10%.

Friday afternoon, there were rumors of a rescue package agreement in Europe and the stock market had a fairly dramatic turnaround. As of the time I’m writing this, the details have not be revealed, nor has the agreement’s existence been confirmed, but I have to believe there is a scramble going on to reveal some positive news before Asian markets open tonight and definitely before the U.S. market opens tomorrow. What happens this week is highly dependent on whether there is an agreement, and if there is one, whether the market believes it will work.

Adding fuel to the fire now is S&P’s downgrade of the U.S. credit rating on Friday night. There were rumors of the downgrade happening on Friday all week, and pretty strong ones on Friday morning. S&P telegraphed the measure to allow markets to prepare so it wouldn’t be a shock to the system. My personal opinion is that this is the last straw in S&P’s credibility as a rating agency (these are the same people who rated the mortgage-backed securities that went belly-up in our crisis as AAA in many cases). While my opinion of S&P is not relevant, the market’s opinion of U.S. long-term debt is, and it’s far more relevant than S&P’s opinion of U.S. long-term debt. A $14.3 Trillion market is made of so many people, institutions, and countries that to think S&P has some crystal ball, research ability, or magical formula that the collective $14.3 Trillion worth of market of participants does not have, is ludicrous. We need S&P to do the due diligence on individual companies and their sometimes hundreds of securities because there isn’t enough time in the day for every fund manager or individual to do the research on their own. But here, we’re talking about the U.S. government. Do we really think that China isn’t doing their homework on our ability to repay our debts before they decide to lend us a trillion dollars at 2.5% interest for 10 years?!? There’s no doubt we’re on a bad fiscal path, no doubt. Without getting into political views, I think it’s also safe to say that our political system is showing signs of weakness as well. But the markets say we’re the safest thing out there. Add in our ability to print money as a last resort if we need it, which we could use to pay off debts at the cost of high inflation, and there’s just no more chance of default today than there was before the S&P downgrade, and certainly not more chance of a default than during/after World War II.

So what does it mean for the markets? Unfortunately, despite the fact that the downgrade was telegraphed and essentially priced into the market in advance, there are some short-term technical problems that can result from the actual downgrade. There are funds (pension funds, mutual funds, etc.) that have legally obligated themselves to hold AAA-rated securities for a certain percentage of the fund. If they hold long-term U.S. debt, they will be contractually obligated to sell. This forced selling could drive down prices of U.S. Treasuries which in turn drives up interest rates. Over the medium term, I believe others who aren’t contractually obligated to sell will see great value in treasuries at a higher rate and will swoop in to buy up all the Treasuries that the other are coughing up. Short-term though, the forced selling could create instabilities and dislocations in the market. Selling can beget selling and the spillover effects to other markets like the stock market can be severe. In addition to the forced selling, there is the problem that banks, states, government agencies, and municipalities rely on the Federal government as a last resort for funding. The government is now rated AA+, all those organizations who are AAA likely have to be re-rated lower. If you believe the S&P downgrade, you can’t put your full faith in FDIC insurance, in social security, in Medicare, in Fannie Mae and Freddie Mac (who hold about 50% of the mortgages in the U.S.), or well-capitalized U.S. banks. Downgrades of all those entities could cause a domino effect on everything that relies on them. Trying to see the end of the line of downgrades due to this one is impossible.

But, in thinking about it, I keep coming back to the same thing. There’s not a single entity today who has a lower chance of repaying its debts than last week. If that’s the core guiding principal, then everything else has to have at most a short-term impact. Dislocations in markets that cause violent reactions should have a snap-back effect as value is recognized by those who are not obligated to sell. Of course when dealing with markets like the stock market, we never know how long short-term will last and how long it takes to get back to something grounded in fact, value, and thought vs. rumor, momentum, and fear.

In short, I’m not worried about the S&P downgrade. What happens over the short-term is unknown. It could be very ugly. There’s a part of me that thinks that ugliness would be very short-lived and we could even see the market rise this week if Europe makes a credible announcement that would end their financial downward spiral. So, I’m watching Europe, way more than I’m watching S&P’s opinion about something that $14.3 Trillion dollars have already decided. The U.S. bond market is safe and we remain one of, if not THE safest place to have money in the world.

What we’re doing is preparing to rebalance all portfolios as triggers to do so occur. We don’t anticipate a negative response to short-term bonds which is what makes up much of the conservative portions of your portfolios. As stocks fall, if they fall enough, we will sell bonds and buy stocks to rebalance your portfolio back to its target. It is the same thing we did during 2008/2009 and the reverse of what we’ve been doing as the stock market rose 100%+ over the past 2 ½ years. This results in a natural buy low sell high rhythm that doesn’t require us to predict bottoms and tops in the market, something I know is impossible. 50% of everyone who makes and up or down prediction are going to be correct. You just can’t know ahead of time who they are or that they’ll be in the same 50% the next time. Note that this rebalancing strategy only works if your target allocation is aligned with your broader financial plan. I’m sure there are people out there (obviously not PWA clients) who are 6 months from retirement and have their 401k in funds that hold 90% stocks. I’m sure there are others who want to buy a house in a year and they have most of their liquid assets, needed for the downpayment, in individual stocks. They probably felt pretty good about their portfolio as little as 3 weeks ago but now there’s a chance they can’t buy that house all because their plan didn’t align with their portfolio. As Vanguard’s chief economist Joe Davis has said, “Treat the future with the humility it deserves.” Planning is a much better way to do that than gambling or hoping.

I’ll send out another update (hopefully shorter) as events warrant. As always, if you have questions or comments on this topic or anything else, please don’t hesitate to ask.