In the wake of the S&P downgrade of U.S. debt, it should come as no surprise that there is panic and confusion in equity markets around the world. But is this event a trigger for more downgrades (think: Europe) that might escalate the panic further? Or is this simply a reaction to an event that was, for most people, inconceivable?
There’s considerable evidence that panic may not be warranted. After the devastation caused by the rating agencies' failure to properly rate toxic mortgage bonds, they have a vested interest in being ultra-conservative. Said another way, they are looking for pessimistic evidence to justify an ultra-conservative outlook. If they say the world is going to end, but it doesn’t, people won’t sue them.
The U.S. Treasury department posted an article where it actually caught an arithmetical error S&P had made in its analysis, before it went public Friday evening, overstating America’s debt by $2 trillion. The S&P acknowledged this mistake but proceeded with the downgrade anyway.
This reflects that the downgrade was not simply about numbers. It is obvious that America has an enormous amount of debt and its economy has yet to recover from the recession. The downgrade, coupled with a negative outlook, simply reflects S&P’s sentiments towards America’s debt and the inability of its politicians to address the problem in a meaningful way.
The downgrade was not severe enough to force institutional investors (pension plans, central banks, insurance companies, etc.) to stop holding US Treasuries. For all intents and purposes, this downgrade can be viewed as a very harsh warning. While it may cause institutional investors to seek diversity in their reserve assets, there is still a shortage of safe financial assets in the world, and America’s debt still remains among the safest. In fact, the financial situations of Greece and Italy are more alarming.
This is not to discount the warning itself. The S&P’s downgrade merely formalized what China and many central banks around the world are concerned about. The question that the world wants answered is: What prevents the next attempt at fiscal reform from being as excruciatingly incompetent as this one? What assurances can America provide the world that substantive debt reduction is actually on its way?
America’s answer is the Super Committee, an attempt to exclude radical members of Congress from having too much influence over America’s path toward fiscal responsibility. It is hoped that this committee understands that any meaningful solution has to include both tax hikes and spending cuts. Though the S&P’s analysis was sentimental more than fundamental, the failure of this Super Committee will lead to a severe and warranted panic. In the end, America needs to the world a plan that makes sense. There's time, for now.
Meanwhile, markets around the world are dropping sharply. In developed countries, there is a need for cash among insurance companies, pension plans and banks, as they must prepare for demographically driven payouts to meet the demands of an aging population. For individual investors as well as institutions, selling at this moment is not an option; it’s a requirement. Because the duration of the panic is difficult to predict, as is the frequency of future similar stock market reactions (for example, what is about to transpire in the eurozone makes investors just as anxious), the need for cash outweighs patience.
For investors who have the cash, purchasing blue chip stocks that have demonstrated a high dividend yield is an excellent strategy to employ in the wake of the current panic. Equities have shown great resiliency throughout the recession and have exceeded expectations for most of 2011 through increased productivity. Their stock prices do not reflect these financial results.
Here is a relatively diversified group of high dividend-yielding stocks (between 3.5-4.2%) that make attractive targets in the plummeting markets: Intel (INTC), Phillip Morris International (PM), General Electric (GE), Heinz (HNZ), Conoco Phillips (COP) and Abbot Labs (ABT). All these stocks have respectable P/E ratios and should outperform for the remainder of 2011.
Finally, two Canadian stocks that should be considered are Manulife Financial (MFC) and Power Corporation of Canada (PWCDF.PK), both listed on the Toronto Stock Exchange. These stocks were undervalued before the panic started. In general, Canadian financials are extremely healthy institutions that have shown the ability to bounce back after widespread market drops, such as the one happening now.
Make no mistake; this is a buying opportunity for the buy-and-hold investor. Unlike short-sellers, such windows are rare for long-term investors.
Disclosure: I am long MFC and PWCDF.PK.