Strange Day, Followed by Strange Night. What Now?

by: Roger Nusbaum

Note I was going to publish this Saturday morning but news of the downgrade (which I get to toward the end) came out while I was working on it. For all we know the news may change yet again.

I am writing this post early on Friday evening so the new may change by the time this publishes. Friday was a very strange day in the markets and in the news.

Obviously there were some big swings in terms of opening up big, sort of whooshing down, and then more up and down before closing flat, but the huge number of SPX points that the index was moving in a matter of minutes -- or in some instances seconds -- made for a truly strange tape. I don't ever recall that type of minute by minute action where it appeared to be hopping four or five points in either direction throughout the day. Certainly not on a day that ended flat. Seeing strange tape activity on a day like the flash crash or the like is another matter.

The other bit of strangeness is whatever the hell is going on with S&P and the U.S.'s AAA rating. I can't vouch for the various news stories going around that S&P was going to issue a downgrade and then changed their mind, but there were rumors in the market for most of the day on Friday that there would be a downgrade over the weekend (Friday night); then there were reports (I saw mostly on Twitter with news sources cited) that the White House applied pressure somehow (there were mistakes in their math? really?) on S&P and they backed off.

First, any criticisms against the ratings agencies are deserved and I doubt there is any restoration of their reputations possible, but the ratings do matter on some level. Again, maybe they shouldn't, but they do.

The feeling I get is that this was going to happen which, as raised in a tweet by Pedro da Costa from Reuters, makes you wonder how something like this could get leaked to the point of being widely disseminated? Shouldn't someone fry for this?

As far as the notion of S&P making an error, while I do not know their process I am shocked to hear that the various doublechecks in place (there are doublechecks, aren't there?) did not catch the error much sooner -- even something unofficial like "Hey Joe (guy in the next cubicle over), gotta second? Does this look right to you?"

The way this is being portrayed (tonight anyway) is "ok, let's go with it! ... wait, what do you mean you found an incorrect number in row 231 column BE?" While I'd like to think this is not how it went down, it is what it feels like.

I believe it is obvious that if the details of the U.S.'s current situation were applied to any other country, that country would be downgraded without a lot of controversy. One point I've made repeatedly since the crisis started is that the U.S. is in a unique situation by virtue of its role in the world economic order. The rest of the world has a vested interest in America's welfare, which ultimately will prevent the type of perpetual panic in the streets that some people have been calling for since 2007 if not earlier.

"No perpetual panic in the street" is not exactly a compelling investment thesis, however. As I've been saying for years, this crisis will take a long time to work through; in some ways things are getting worse and in some other ways things never got better, or perhaps more correctly were masked by QE and other desperate policy measures that have come and gone since.

As opposed to debating whether the U.S. should or should or should not have an AAA rating or whether there will or will not be QE3 (or some other desperate measure) it makes sense to just reduce your exposure to these problems. Clearly a short-term decline will be felt everywhere, but in terms of where we are at the end of some reasonably long period of time, markets ex-the trouble spots will be much farther ahead -- at least that is how we are positioning.

Well, I was about to hit the publish button when I noticed my Twitter feed blew up with news that S&P downgraded the U.S. after all. I told my wife and she asked what this means. Generically it should put upward pressure on interest rates and downward pressure on the currency, but again the U.S. has a unique role in the world economy by virtue of our being the biggest customer for many countries, by so many countries having their currency pegged to ours for one reason or another and because many transactions conducted between other countries are done in U.S. dollars (although the trend is for less and less of this).

I don't know what to expect from the bond market as rates seem obvious, but if something were to ever confound the obvious this would be it. I would think this will also be disruptive for equities for a time before we go back to worrying about Europe and our economy.

Comparisons to Japan do not stand up, in my opinion, because Japan has a different saving dynamic and never played the same role that the U.S. does in the world economy. Interesting is how Tim Geithner made it very clear that a downgrade was off the table. Dude? Why say anything unless he wants this to be his out?