There was a time when Wall Street would sell off after a major listed firm would miss earnings expectations. There was a period Wall Street would sell off if a major economic indicator went in the wrong direction. There was an epoch when Wall Street would sell off any time government deficits would tick upward.
In 2001, this was an “old” mentality, as the Fed wrote a put to support Wall Street, cutting interest rates anytime the economy weakened or a beloved asset like real estate declined in value. In this way, the Fed nurtured a “new” win-win mentality among traders: The economy gets stronger, stocks and real estate climb. Katsingo! The economy falters, the Fed cuts rates, everything goes up.
For a while, traders and the Fed got it right, the stock market continued to climb and everyone was making money until 2007, when residential and commercial real estate collapsed, taking Wall Street along for the ride. But then the Fed returned writing several puts to support the market, launching QE1 and QE2, and the win-win-mentality returned on Wall Street: The economy gets stronger, stocks go higher. The economy gets weaker, the Fed goes on with QE3, and QEn, and the market goes higher.
Standard & Poor's, issuing of a “negative” outlook on U.S. government debt, is about to change this mentality, bringing Wall Street back to its old “old” mentality. Here is why:
- It will undermine the Fed’s ability to launch another round of QE, as it will raise the likelihood of an S&P downgrade that will drive long-term interest rates higher. The Fed may be priced out of the put market.
- It will shave earnings expectations to allow for the prospect of an eventual downgrade.
- It will make U.S. assets less appealing to overseas investors, as they have to be re-priced.
- It will make it increasingly difficult for Washington to continue its free spending policy.
Wall Street may have to return to the “old” boring mentality, where traders cannot count on the Fed and Washington puts.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
