Here Comes the Sink

It was a wild week for US markets. Volatility was off the charts and on Thursday the Dow dropped 512 points – its ninth largest single-day drop in history.  Stocks are down about 7% from their peak in April and are now negative for the year.  Then on Friday, adding insult to injury, Standard and Poors stripped the US of its coveted AAA credit rating (down to AA+).  Of course, it wasn’t unexpected, the writing had pretty much been on the wall – you can find my previous comments on the matter here.

The question now is what will it mean for the bond market moving forward?  In the ultimate scheme of things, and maybe surprising to some, it probably won’t mean that much.  Markets tend to see things in relative terms, “better or worse” can have more sway than “good or bad.”  Sure, debt problems may look bad in the US right now,  however, are things worse than in other parts of the developed world, relative to Europe or Asia?  I doubt it.  In Italy, debt to GDP is 119%, in Japan, it’s a mind-blowing 220%!  Figure 1 shows those percentages relative to the US.

Figure 1 Debt to GDP (%)
Source: International Monetary Fund, BCM
Yes, the US was downgraded, but then again, Greece was cut all the way down to junk.  The point is that in a world of bad or worse, the US is still considered a safe haven.  That’s shown by the fact that Treasury yields have actually been declining even in the face of looming default and threats of potential downgrades.  At the end of the day, I don’t think S&P’s rating change will cause a substantial rise in Treasury yields. Though over-indebtedness can place upward pressure on interest rates, I think we are still some time away from that point.
As for now, so long as economic uncertainty remains, Treasuries are likely to retain bids and stocks are likely to stay under pressure.  Given the weakness in this week’s ISM and employment figures,  the risk of recession is still in play.  And if a double-dip scenario actually gains more momentum,  the S&P 500 could revisit the 900’s along with a whole lot more volatility.  And should that really happen, be sure to keep the big picture in mind. I know 500 point dips in the Dow can make investors feel like the sky is falling, but it’s important to remember that ultimately it will not.
Outright Armageddon aside, the stock market will not go to zero, and  I doubt we’ll ever even see the S&P in the 600’s again.  Yet be that as it may, during periods of heightened market fear, panicked sellers don’t discriminate. The good, the bad, and the ugly all get thrown out the window along with the kitchen sink.  And it’s during these very moments when keen investors can find some good deals.  For example, during the financial crisis, the S&P 500 fell by 57%.   While some stocks deserved a 50% haircut, was every major public company in the US suddenly worth only 43% of their previous valuations?  Of course not.

Some blue-chip bellwether stocks were basically cheap for no good reason.  3M was trading at $42 (now $84), Boeing at $30 (now $62), and Apple with all its iPhones was under $100 (now over $370).    Then again, there were plenty of well-known stocks that have not recovered commensurately, Walmart and AT&T for example.  The point is opportunities to buy good companies at deep discounts are few and far between.   With uncertainty mounting and volatility on the rise, the chances of encountering another opportunity are increasing

Of course, “stock-picking” isn’t a central party of my investment strategy.  In my opinion, maintaining a properly balanced portfolio appropriate for your circumstances is more important than any stock pick will ever be.  I see stock picking as a supplemental tool that can be useful in certain situations.  It’s important to know how to use it and what to look out for, otherwise, we could end up getting smacked in the head with something unexpected.  And if everything does get thrown out the window, the kitchen sink will really hurt!

Victor K. Lai, CFA

This blog is for informational purposes only. Nothing on this blog constitutes investment advice. Bellwether Capital Management LLC does not provide tax or legal advice. You should conduct proper due diligence and/or consult with your professional advisers before taking any investment action.