Standard & Poor's is Right (in Principle), but Wrong (Again)

Written by Joe Pitzl, CFP® | 08 August 2011

In an attempt to regain any tiny bit of legitimacy that still remains at Standard & Poor's (S&P), the rating agency sent shockwaves across the globe last Friday evening by downgrading the United States from AAA to AA+.

What does this mean? First of all, it means that AA+ is now the gold standard for S&P ratings. Second, people will panic and make some bad decisions. Third, a lot of companies, countries and agencies are going to have to be downgraded as well. Fourth, the other rating agencies have not changed anything and have not downgraded the US (and one of them, Moody’s, gives their reasons here). Finally, S&P is going to be mocked and ridiculed to no avail, however, they have no one to blame but themselves for their quality of work over the past several years.

For those who want a quick update of what is happening, simply note that your portfolio strategy is sound and designed to insulate you in bad markets. You are not going to be impacted anywhere near as much as the nightly news is indicating, nor are you going to be impacted like the overall market is being impacted. In 2003, Howard Marks wrote that “there is a time when it’s essential that we beat the market, and that’s in bad times” (recall the chart below from previous posts). Not only do we agree with this statement, but rest assured, right now you are.

As Warren Buffett states, “be fearful when others are greedy and greedy when others are fearful.” The rebalancing that has been taking place in your accounts over the past several days has been an intentional effort to reallocate some dollars into quality investments that have been beaten down the past several months. We recognize this is coming at a time where the media is spreading fear, and the S&P decision over the weekend only fuels that.

We have been writing at length over the last year about the importance of managing risk before worrying about returns, rebalancing dollars out of more volatile small companies and moving that money into larger, more stable companies, reallocating your bond allocations globally, and raising cash to provide for your income needs. We rely on process and discipline to guide investment decisions rather than reacting based on emotion. Periods like the one we are currently going through are precisely why.

In response to the downgrade, investors worldwide sold stocks over the weekend and bought more US treasury debt. No, that is not a typo. When a rating agency downgrades your debt, it means that they think it is less likely to be paid, yet people are actually going out and buying more of that debt at a higher price today. They are selling their holdings in companies that are minimally (if at all) impacted by this and buying the debt of the very country that just got downgraded. This means that either (a) the market believes that S&P ratings have no credibility whatsoever, or (b) investors are simply panicking. Our guess is that both elements are factors today. As Burton Malkiel (author of A Random Walk Down Wall Street) wrote this morning in the Wall Street Journal, “This is not the market meltdown of 2008 all over again. And panic selling of U.S. common stocks will prove to be a very inappropriate response.”

If we remove emotion from the equation, this phenomenon makes no rational sense. If the downgrade is valid, people should be selling treasuries today instead of buying them, bidding up the price and driving down the yield. Benjamin Graham stated that “in the short-term, the stock market is a voting machine. In the long-term, it is a weighing machine.” Our Sharpie-wielding friend, Carl Richards of www.behaviorgap.com, created a simple sketch years ago to echo this sentiment:

This decision comes on the heels of our country’s elected “leaders” waiting until the final hour to raise our debt ceiling, and neither side willing to compromise at all. Not surprisingly, these “leaders” on both sides of the political spectrum immediately started kicking and screaming as loudly as they could that the other party is to blame. The irony here is that Standard & Poors actually made it clear that they took the political landscape into consideration during their analysis, so the immediate aftermath and mudslinging had to be pretty amusing to for them to sit back and watch.

Let’s face it, we have a big debt problem in the United States. We got drunk on prosperity over the last few decades and the time has finally come to pay the bills. This proverbial “shot across the bow” may be exactly what our elected “leaders” need to start taking our country’s financial health seriously.

However, within minutes of their announcement, the US Treasury Department pointed out a $2 trillion mistake on the part of S&P in their analysis, which they fully acknowledged and merely shrugged at. $2 million is a blip on the radar, $2 billion is notable, but $2 trillion? That is downright absurd and reprehensible for a company of S&P’s stature and responsibility. In recent years, the term “trillion” is thrown around in a fairly ho-hum manner, however, to put that term in perspective, click here. We are talking about a huge number here!

Credit ratings issued by Standard & Poors are supposed to represent probability of the first dollar of default. The US is not going to default on its debt. We are not like Greece and Italy, who gave up their sovereign currencies to adopt the Euro. We can literally print $14.5 trillion tomorrow if we wanted to and pay off all of our debts immediately. Greece and Italy can’t print Euros. No EU nation can print money. In reality, printing that much money would be a terrible decision for the US to make, but it is possible to avoid default.

If the United States of America is “only” a AA+ rating, then AA+ ought to be the new benchmark. We are actually seeing that transition in real-time this morning, as S&P has already downgraded dozens of institutions and agencies today. Warren Buffett went on record over the weekend stating that if it were possible to do so in the current rating system, he would actually upgrade the US to AAAA, which doesn’t exist.

While the $2 trillion mistake is clearly an egregious error, let’s also not forget that Standard & Poors is the same group that:

-         Rated boatloads of subprime debt as ‘AAA’, fueling the fire that resulted in the 2008 financial crisis.

-         Raised the credit rating of Bear Stearns an astounding 5 notches to AA- in March of 2008…the same month they declared bankruptcy.

-         They had Lehman Brothers, as a company, rated ‘A’ the week they went under, and reaffirmed its ‘AAA’ rating on some of their securities just three days before it went under.

-         Merrill Lynch and Morgan Stanley were rated ‘A’ and ‘A+’, respectively the week they had to be bailed out.

-         Had an ‘A-’ rating for Iceland in September of 2008 when the country was forced to guarantee all bank deposits after its currency plunged.

-         Downgraded Berkshire Hathaway and its $46 billion of cash.

Nobel Laureate, Paul Krugman, said in the New York Times, “There is no reason to take Friday’s downgrade of America seriously. These are the last people whose judgment we should trust.” Here is a comical sketch of the S&P rating model from Barry Ritholtz today:

Right or wrong, S&P kicked up a storm, but we are not convinced they have told us anything we already didn’t know.

We have been spoiled with a tremendous bull market the last 2.5 years. While it certainly does not feel good, a correction such as the one we are experiencing is not a surprise, nor is it abnormal. In the first half of 2010, for example, many people forget that the market experienced a 17% decline (which is greater than the current downturn), yet finished the year ahead by double-digits. As mentioned previously, your portfolio has not (and will not) experience as severe a decline as the overall market.

Rest assured, those of you who need cash from your portfolio over the next several years have money set aside for that purpose, and in general, you are well-positioned to weather this period and come out ahead in the long-run.

We can control the process of investing, but we can’t control markets, herds, rating agencies, or politicians. Turn off your TV’s and get out and enjoy the summer while it lasts.

Intelligent Decisions.               Simplification.               Peace of Mind.