The Effects of the Downgrade

By now, you’ve no doubt heard that Standard & Poor’s has downgraded the U.S. credit rating one notch. Let’s first understand that this downgrade is more a political statement than a financial one. And it’s not likely to affect U.S. Treasury yields much.

I think we all agree that the level of debt the U.S. has taken on is not sustainable. Spending cuts are necessary, and that will need to include the so-called entitlement programs.

Let’s hope this is a wake-up call for the U.S. Congress and administration to get their act together and do something meaningful to deal with debt and spending. After all, the U.S. has run big budget deficits before, and they have been reversed. It can happen again.

There is some interesting commentary on S&P’s move out there. Warren Buffett says that S&P "erred" with its downgrade. PIMCO’s Bill Gross says S&P finally showed some "spine." Treasury Secretary Tim Geithner reportedly alerted S&P that is made a $2 trillion error when it projected budget shortfalls out into the future.

I find that particular item — that S&P’s math was off — to be particularly interesting. This is why I say that S&P is politically motivated. If the math doesn’t matter, then it’s the contentious process that led to the recent budget deal that’s a problem.

And clearly, when you have any faction of government that thinks default would be a good idea, or at least tolerable for reaching political ends, you have added risk.

In a way, this debt situation was inevitable. Congress has avoided the Social Security/Medicare issue for several election cycles, even though the writing has been on the wall that these programs were not sustainable. The desire to be elected has trumped fiscal responsibility – and for far too long.

It would have been much better to deal with looming debt when the country was flush. Now, with growth weak and unemployment high, the needed actions are more painful.

Gold prices have gone ballistic this morning. It’s up over $1,700 an ounce this morning as the downgrade raises the fear level. I will be very interested to see if these gains hold. We already saw a very sharp reversal for gold prices last week.

Bond prices are also higher. Just as we saw last week, Treasury bonds are a safe haven investment, no matter what S&P says.

I’m sure some of you may not want to hear it, but it is time to buy stocks. Fear is in the air, and stocks are down over 10% in the last few weeks.

I’d say the S&P downgrade was the last shoe to drop. We’ve seen weak economic data. And now the downgrade.

But the reason this is a buying opportunity is a familiar one: earnings.

In a research note to clients, money-management firm Blackrock (NYSE:BLK) says: "Earnings are up 128% since the market lows in March 2009. In contrast, the S&P 500 is up 80% over that same time. As a result, stock valuations are more attractive now than they were when markets were at their worst during the credit crisis, and particularly so as compared with bonds."

And despite the recent weak economic data, analysts are not incliced to lower their earnings estimates. Bloomberg ran this quote from chief U.S. market strategist at UBS Jonathan Golub on Friday:

"I’m reluctant to overreact to some shorter-term weakness, no matter how real it is, because the market has proven to be unbelievably resilient…If you would have been acting that way for the last two years, you would have gotten killed by this market. Companies have done an absurdly good job of managing through this environment."

Last year, after the market sold off 14% after the economic data weakened, strategists also remained bullish. And the S&P 500 rallied 20% from its August low.

Of course, QE2 helped that rally along. And I’d be surprised if the Fed acts now, with so much focus on debt and deficit spending. But the bottom line remains: corporate earnings are strong.

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