What the Moody's Warning Means for Wall Street and How to Play It

by: BubbleBustInvesting

Concerned over the dragging debt talks, Moody’s investors Services placed the U.S. triple Aaa bond rating under review for posible downgrade.

Coming almost three months after Standard & Poor's issuing of a “negative” outlook on U.S. government debt, Moody’s warning shouldn’t be taken lightly by Washington and Wall Street alike — as it is a crude reminder to both politicians and investors that there is another factor that determines interest rates: sovereign debt risk. And the European experience has already taught both parties what even a small dose of sovereign risk can do to credit and equity markets — especially to counties with heavy foreign debt.

Though a European-style crisis is very unlikely for the time being, the two warnings will change the Wall Street game in a number of ways:

  1. They will raise uncertainty, as markets will trade more on political news and less on fundamentals.
  2. They will undermine the Fed’s ability to launch another round of QE, as it will raise the likelihood of a downgrade that will drive long-term interest rates higher. The Fed may be priced out of the put market.
  3. They will shave earnings expectations to allow for the prospect of an eventual downgrade.
  4. They will make U.S. assets less appealing to overseas investors, as they have to be re-priced.
  5. They 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. Investors may want to buy their own puts to protect themselves against growing uncertainty with four trades:

1.Buy iPath S&P 500 VIX Short-term Futures ETN (NYSEARCA:VXX) to profit from rising volatility as investor sentiment will frequently shift from bullish to bearish and vice-versa with the release of government indicators that may give conflicting signals on the economy.

2.Trim long positions in iShares Barclays 20 year Treasuries (NYSEARCA:TLT) or even consider buying Proshares UltraShort Lehman 20+ Treasuries (NYSEARCA:TBT).

3.Trade commodities on the short side of the market with ETFs, like SPDR gold shares (NYSEARCA:GLD) and Ishares Silver Trust (NYSEARCA:SLV), and Oil Service Holders Trust (NYSEARCA:OIH) that have been benefited from QE2 and free hand spending from Washington.

4. Trade on the long side defensive stocks with solid fundamentals and a good dividends like Pfizer, Inc. (NYSE:PFE), and Bristol-Myers Squibb (NYSE:BMY) that recently announced positive results of the late stage trial of blood thinner Eliquis.

Disclosure: Long VXX, TBT, PFE, BMY, Short: SLV, GLD, OIH