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Market Insights


U.S. Debt Rating Downgrade: Equity Market Consequences


As I often suggest, there are both social and market consequences to the actions emanating from Washington D.C. In some instances the consequences are similar, in some cases completely opposite. With Friday (August 5) evening's S&P downgrade of the U.S.A.'s long-term credit rating from AAA to AA+, let's explore the potential equity market consequences.
Unfortunately, the downgrade comes on the heels of a 12% decline in the S&P 500® Index since its 2011 high of 1370.58 on May 2. Of greater concern is 11% of that decline has occurred since the afternoon of Friday, July 22, when it became obvious to the market that Congress and the president would fail to privately negotiate a meaningful budget reduction. The S&P 500 Index (Fig 1.1) is now at its lowest level, 1199.38, since November 30, 2010. For the month of August, the S&P 500 Index is down 7.2%. Pessimism and fear currently prevail.
Critical question #1: "Why is the market declining so fast?"
The answer, plain and simple:  "The machines are in control."
The first week of August is a classic "summer week." Trading desks are sparse as money managers are on vacation. What I have witnessed this week is an extreme absence of market liquidity. The "machines" - short-term algorithmic black boxes and high frequency trading - have far more ability to control the tape on an intraday basis. Hedge funds and investment banks are less willing to take risks in the wake of the 2008 credit crisis. Therefore, bids are evaporating, which creates intensive stress within the marketplace. Under these circumstances, volume is an incorrect measure of market participation as much of the volume is attributed to intraday black boxes.
Critical question #2:  "Is this 2008 all over again?"
The answer:  "I do not believe it is."
If you believe this is 2008 all over again, you must expect the S&P 500 Index is in the initial stages of a decline that will continue throughout the remainder of 2011 and take the Index much lower than current levels (Fig 1.2).  You must also believe a global recession is about to unfold.
Consider the evidence supporting my expectation that 2011 isn't 2008 all over again for the equities market: 

  • U.S. ISM Manufacturing:  On August 8, 2008, the four-month average of this Index was 49.1 (signaling contraction) vs. 55.0 today:
    • 2008 - 48.8 (May); 48.8 (June); 49.0 (July); 49.6 (August)
    • 2011 - 60.4 (May); 53.5 (June); 55.3 (July); 50.9 (August)
  • Corporate Earnings:  Compare sales and EPS growth for 2008 vs. 2011 (S&P 500 Index, July to October reporting period):
    • Consumer Discretionary               Sales Growth 2008 +2.14%; 2011 +15.97%             EPS Growth 2008 -5.62%; 2011 +10.72%
    • Financials                                   Sales Growth 2008 -8.19%; 2011 +2.62%                EPS Growth 2008 -55.30%; 2011 +7.57%
    • Technology                                 Sales Growth 2008 +11.76; 2011 +18.46%               EPS Growth 2008 +15.69%; 2011 +31.83%
    • Materials                                    Sales Growth 2008 +18.43; 2011 +17.80%               EPS Growth 2008 +8.40%; 2011 +47.49%
  • Spot Oil:  On August 5, 2008, the 60-day average spot oil price was $ 133.54. In 2011, it is $95.87.
  • U.S. Payrolls:  On August 5, 2008, the U.S. labor market had reported six consecutive monthly losses at an average of -164,000. In comparison, the trailing six months for 2011 are currently all positive with an average of +144,000.
Summary: The market consequences of the S&P downgrade are rather uncertain near term. Will the markets be down another 2%, 3%, or 5% on Monday? That is nearly impossible to predict. However, five months from now, I expect equity investors will look back upon the challenging summer days of 2011 as they did when looking back at the summer of 1998 in December of that year (Fig 1.3).
The Week Ahead - Important inflation data from China will be released on Monday, August 8, and the FOMC meets on Tuesday, August 9 (no press conference). Both of those events are worth watching.   
Fig 1.1 S&P 500 Index, 8/20/10 to 8/5/11
Source: Bloomberg
Fig 1.2 S&P 500 Index, 8/08/08 to 3/10/09

Source: Bloomberg
Fig 1.3 S&P 500 Index, July 1998 to December 1998

Source: Bloomberg

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