MR. MARKET, THE RATING AGENCIES, AND MORE

8/6/11

People have asked me my opinion of the stock market’s travails (the Dow was down 700 points) of the last week. What happened? Everyone seems to have an opinion, and I wish I had a more artful guess, but it all seems quite simple.

We have a lot of financial (and other, but that’s grist for another mill) problems in the world today: Europe’s difficulties, our inability to get our fiscal house in order, an economy in the U.S. that seems to be, at best, stuck in neutral, the perception that, this time, governments, whether in the U.S., Europe, or Asia may not have the wherewithal to save everyone’s bacon, etc. Of course, as I have been saying ad nauseam since the inception of this blog in February of 2007, and even before that in its predecessors, all these problems have their root in too much debt taken on by too many people and other entities who feel entitled to live well beyond their means. But again, that is another issue.

At the same time we are experiencing all these difficulties, the market is not trading cheap. In today’s (8/6/11, page B1) Wall Street Journal, Jason Zweig points out that, using Benjamin Graham’s concept, later refined by Robert Shiller of Yale, of “cyclically adjusted” price earnings ratios, the S&P is trading, after last week, at a multiple of 20.2 times, down from a peak at the end of July of 22.9. The fifty year average for this cyclically adjusted yield is 19.5. So, by this measure, the market is not trading excessively rich but certainly isn’t trading cheap.

The U.S. economy is, at best, treading water and the world economy is not doing much, if at all, better. The domestic and international financial system is fraught with peril and is suffering, at least in the eyes of this observer, from a dearth of grown-ups in positions of power. There is little confidence in the political system in this country, in Europe, and, to perhaps a lesser extent, most places in the world. It looks like no government anywhere is in a position to do its much heralded, and vastly overrated, deus ex machina routine and seemingly save the day at the last possible moment. And stocks weren’t trading cheap, using either the “cyclically adjusted” P/E of 23 or the conventional P/E of almost 16 at the peak before last week’s debacle. Is it any wonder stocks took a tumble? Will they fall further? By the same measures, it seems logical to think they will, but predictions on directions of the market are foolish at best and dangerous at worst.

And on that last note, another question has come up: What will S&P’s downgrade of long term treasuries from AAA to AA+ do to the market? Again, predictions are perilous, but probably not much will come of S&P’s actions for a number of reasons, including:

--Moody’s and Fitch maintained their Aaa and AAA ratings, respectively, on long term U.S. debt, at least for now.

--S&P maintained their AAA rating on short term U.S. debt.

--As someone put it, a downgrade from AAA to AA+ is like a downgrade from a Lamborghini to a Mercedes. Anyone who knows anything about cars wonders why such a move would be a downgrade, unless one is married to a mechanic who speaks Italian and has an endless supply of spondulicks for parts, but I digress.

--The rating agencies aren’t telling anybody anything he or she doesn’t know, as usual

Especially ludicrous, as I pointed out last week (MAYBE WASHINGTON ISN’T SO BYZANTINE AFTER ALL, 7/30/11) are predictions that the “government will have to pay higher rates of interest on its debt” and that “mortgage rates and other rates that key off treasury rates will skyrocket.” Some investors are being even, in a way, less modest by putting a number on such dire predictions, saying that treasury rates will go up 50 basis points. Yet, since this “crisis” started, treasuries have gone on one of their biggest rallies in their history, with the 10 year’s yield falling as low as 2.40%, its lowest yield for the year, before reversing course to 2.56% on Friday. (One could argue that the addition of 16 basis points to the ten year’s yield on Friday had to do with wind of the downgrade getting out, but even if one accepts that stretch, just consider how much the 10 year’s yield has fallen in the last month or so…it was at 3.11% at the end of June.)

So if the stock market does take a tumble in the coming weeks, or days, it shouldn’t have anything to do with the downgrade, but this, like so many guesses about where the market is going or why it went where it went, is an untestable proposition. And if the stock market tumbles, it’s a pretty good bet that treasuries will rally, at least in the short term; it’s hard to see how rates stay this low for the long term, but that particular guess has nothing to do with S&P, Fitch, or Moody’s.