The news has been dominated all weekend by the announcement that S&P downgraded U.S. debt one notch from AAA to AA+.  There has been so much coverage on this issue that it is difficult to filter through and figure out what it really means for the stock market.

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Not Really a Surprise

I'm really not sure why so many people were caught by surprise.  I stated on July 26 that we were close to the end of AAA ratings.  The "compromise" that was reached to end the debt ceiling circus was not even close enough to reach the $4 Trillion in REAL spending cuts S&P had already said would be required to keep the AAA rating. 

The spending cuts that were part of the debt ceiling deal will do little to change the pace our country is growing its debt.

There are a lot of assumptions taken to come up with $2.2 Trillion of spending cuts in 10 years and the impact it will have (more on that in a minute).  Taken at face value, if Congress actually sticks to those spending levels through 2021, our debt will grow by $5.5 Trillion.  Let's put that in perspective..........our TOTAL debt when George W. Bush took office in 2001 was $5.6 Trillion.  How is a country that plans on increasing its debt by AT LEAST 100% in 20 years deserving of a AAA rating?

A Political Statement

One thing that was very apparent in the statement released by S&P is that the key driver of the downgrade is that they have no hope that Congress will be able to make significant progress in tackling our debt problems.  How can you blame them after watching Congress operate this year?  They wasted 3 months arguing over the bar tab on the Titanic to agree to spending cuts that amounted to 10 days' worth of interest expenses. 

The ramblings over the debt ceiling only cemented most people's belief that Congress is not capable of making REAL spending cuts that will make a dent on the amount we are borrowing each year.  Here is what S&P said:

"The downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011."

What they didn't say, but was implied in their statement, is that this group of Congress has no spine and no willingness to tackle the real problems.  Some may say they want to tackle the big issues -- Social Security and Medicare, but when polling numbers come out that show them losing favor because they want to reform Social Security or Medicare, they quickly back down.

Until something is done with these two programs to get them back on sound footing, further downgrades will be necessary.

Who Really Made the Error?

A lot was made over the "$2 Trillion error" S&P made in their assessment.  The Treasury Department issued a scathing letter discussing this error.  Rather than go into the details of fiscal accounting, which has so many tricks and hidden assumptions to make things look better than they really are, let's look at one thing that jumped out at me as I read the Treasury's  response.

CBO assumes that nominal GDP grows by just under 5 percent a year on average, while inflation is around 2.5 percent a year on average.

WHAT?  Last I heard CBO was using the 3.3% "normal" GDP growth in their estimates.  Given the fact that our economy hasn't been able to grow above 4% since 2005, we can assume that the budget deficit will be MUCH higher than they are assuming.  Look at the trend in GDP growth over the past 30 years.

The other thing this reminds me of is the fact that CBO estimates never take into account a recession.  Does anybody here believe that our economy will be recession free for the next 10 years?

Judging Guilt by the Response

One thing we've learned by having 6 kids, and something our police office friends will tell us, is that more often than not you can determine guilt by watching who has the strongest reaction to an accusation.  I was embarrassed for our country and the Obama Administration watching how they reacted to this downgrade.  Tim Geithner, was the worst of the offenders.  He told NBC that S&P showed a "stunning lack of knowledge about basic US Fiscal Budget math."  This is the same person that

1) had his own personal income tax problems

2) was in charge of supervising the Wall Street banks as President of the  New York Fed during the run-up to the 2008 Financial Crisis

3) lied to the American people by saying the Treasury wouldn't be able to pay Social Security or active duty troops without an increase in the debt ceiling

The truth hurts and the anger towards an independent company stating what they believe is the truth says a lot more about our country than the downgrade itself.  I've heard Congress people mention the words "terrorists" and "traitors" when interviewed about the downgrade.

This really reminded me of those tech frauds in the late 90's that would blast the short-sellers that were willing to point out the truth about a company's financial health.

We are above this as a country and it saddens me the way our leaders have reacted.

Downgrade Really Doesn't Have an Impact

In the whole scheme of things, the S&P downgrade doesn't have an impact that many people believe.  Consider:

1. This was well telegraphed & was probably being priced in last week.
2. It takes 2 of the 3 ratings agencies to cause a big impact (Fitch & Moody's have kept the AAA rating, although both have a negative outlook).  If 2 of the 3 were to remove the AAA rating, then we would have problems as many financial companies can only hold AAA collateral and large investment funds have charters that say they can only own AAA securities.
3. Given the major political backlash that S&P is facing, it is highly unlikely Fitch or Moody's will take the step of downgrading the debt anytime soon.  In fact, Moody's is giving the budget deal until 2013 to work.

What the Downgrade Means to the Market

We provided a full assessment of the market last week in "Where do we go from here?"  Rather than rehashing those points, if you are interested you can go back and read that article, which includes links to more articles that provide further details on each topic.  Our clients expect us to understand what is going on and to be able to explain it to them.  Those articles are there to help you do that.

On Friday I had this sick feeling in my stomach that the market was showing signs that it could crash this week.  I've had this feeling a few times before and thankfully it hasn't occurred.  It's hard to describe a gut feeling, but every once in a while I get flashbacks to 1998, that awful summer of 2002, or the fall of 2008. 

I could "feel" the angst in the market.  There was such a flurry of activity in the market with so many up/down swings early in the trading day.  Volume was so heavy that our primary quote service was having a hard time keeping up -- something that occurred in 1998, 2002, & 2008.  For a while it and a few other quote services were as much as 45 minutes behind in their quotes.  Some indexes stopped reporting prices as they had system glitches.  Goldman Sachs "Prime" clients couldn't even log into their accounts as their computer system was down.

(I am happy to report that TD Ameritrade's platform did not have any delays or outages at all this week.  In fact I was surprised at how quickly our trades were executed and reported back to us.)

As I was wrapping up a 15 hour work day Friday evening, I caught the headline about the S&P downgrade.  My initial reaction was, "wow, this may actually cause a crash."

As I thought about it though, it usually isn't a known event that causes a crash -- it is something that people are not expecting.

Cracks in the Foundation

The market moves based on "consensus" expectations.  In early July we listed the reasons the market was rising.  Those assumptions have been under attack the past few weeks as reality has set in.

Look at the assumptions people were using as they bought stocks and the reasons they are now reconsidering those assumptions:

1. Economic Data getting better -- not only has the economic data worsened, it now appears that the economy is going to have to survive without pain killers.  
2. Europe's Problems Pushed Down the Road -- many people assumed that Europe's debt crisis was kicked several years into the future.  It turns out that Europe couldn't even go two months without having to bailout another country.
3. Market will rally on a debt ceiling deal -- as everyone realized that Congress is nothing more than Professional Can Kickers that do nothing to solve the long-term problems, people lost confidence in our ability to have strong growth over the long-term.  

I've said for quite some time that Europe is a major problem that we cannot ignore.  In my opinion the continued need for the stronger EU countries to bailout the weaker countries is a much bigger concern for th market than the S&P downgrade.

Head & Shoulders Pattern Actually Worked

I mentioned last week that I was reluctant to mention the head & shoulders pattern that had developed because so many of them the past two years had failed to work.  One reason those didn't work is even fundamental investors were pointing towards them.  Once everyone seems to know something is going to happen, the opposite occurs. 

I brought it up because I hadn't heard very many people point this one out.  The breakdown in the market has done a lot of technical damage and this pattern points to some further downside potential in the market.

The market closed Friday about 4% above the downside target.  I also drew a line around 1130 (6%), which seems like a more logical place the market COULD stop.

Whether or not it will stop there and become a strong bottom is really any body's guess.  Sentiment has shifted strongly towards the negative side, which makes me think the selling may be over done.  Of course all I have heard the past 3 days is how this drop in the market is a buying opportunity.  If everyone starts thinking that, then there is likely more downside ahead.

SEM Playing Defense

For the first time since March 2009, our programs are in full defensive mode.  We got more sell signals on Friday.  This reduced our equity exposure in Enhanced Growth (EGA) from 64% to 20%.  Enhanced Portfolio Allocator (EPA) reduced its exposure from 33% to 0%.  Income Allocator (INA) reduced its bond exposure some more and is down to 28% bonds spread out amongst many different asset classes.  Absolute Return (ARA) increased its net short exposure on the close Friday.

One important note that I keep failing to mention -- all new INA, EPA, and EGA accounts have remained invested 100% in CASH since July 25.  This was due to a "warning" that further losses may be ahead.

We've received a handful of phone calls from panicked clients that wanted to move their money to cash.  Some seemed like they wanted to literally put it under a mattress.  One thing we reminded them is that we were already doing it for them.  The key difference is that we are not panicking and moving to cash.  It has been a disciplined, gradual slide towards the defensive side of things.  Our systems are designed to allow some losses as we all know the market doesn't go up in a straight line.

The other key difference is that we have a plan that gets us back into the market should the big institutions decide that the worst is over or that all the negativity has been priced in.

We could see an attempt to rally today following the pent up selling after worrying about the debt downgrade.  That rally could actually gain some legs this week depending on what the Fed decides to do at its meeting Tuesday and Wednesday. 

The market is not likely to care that the Fed is shooting blanks.  They will just be happy that somebody is trying to do something to stop the losses.  As we are learning in Europe and should have learned from QE1 & QE2, the Grand Experiment where the government and central banks can control what happens in the economy is failing.

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