On the first trading day after Standard & Poor's historic downgrade of the United States' credit rating, investors are left with one very big question on their lips: What do we do now?
Within an hour of opening, the Dow had already fallen nearly 400 points, and the Nasdaq and S&P 500 were down even more in percentage terms. Gold soared by more than $50 per ounce to new all-time highs as investors ran for cover.
But perhaps most interesting is the action in the Treasury market. Treasuries were downgraded by Standard & Poor's. In a normal world, this would cause yields to rise, as investors would demand a higher yield in response to lower credit quality. Yet in the upside-down world of today's market, yields instead fell. Investors sell off their stock positions due to the bond rating downgrade…and then promptly plow their money into downgraded bonds. The 10-year Treasury now yields 2.39%.
Before you despair, keep a couple important things in mind: Nothing fundamentally has changed in the economy. It was bad before the announcement, and it is still bad today. But S&P's announcement changes nothing. The Federal Reserve has said that it will continue to accept U.S. Treasuries as collateral and that, as far as the Fed was concerned, Treasury debt still counts as AAA for the purposes of bank capital requirements. In other words, the people that run the international banking system don't appear to be all that worried.
Meanwhile, the European Central Bank has taken unprecedented steps to stop the contagion that many feared would spread to Italy and Spain. The ECB has broken from tradition and gone on a buying spree of Spanish and Italian debt. This should be enough to avert a new round of crisis, at least for the time being.
Still, investors are scared, and the markets are in free-fall. Given this sense of chaos, what are investors to do?
Here are a few suggestions:
Stay out of Treasuries. Do I think that the U.S. government is at risk of default? Absolutely not. I have no doubt that the bonds will be paid. But at a pitiful 2.39%, investors are locking in a cash return that is almost sure to disappoint - and almost certainly capital losses to boot. When the markets return to some semblance of normal, yields will rise back to a more sensible range of 3-4%. That means that investors buying today at 2.39% will see their "safe" Treasuries decline in value. More adventurous traders might want to short Treasuries in the futures markets or using an inverse ETF like the iShares Short Treasury Bond Fund (SHV).
Stay out of gold. I understand the argument that gold is insurance against capital market instability. I get that. But would you buy insurance on your home after it had already burned down? Or on your car after it had already been totaled?
In the real world of insurance, no agent would sell you a policy after the event has already happened, but in the financial world "agents" are all too happy to do so. Remember, gold has no "intrinsic value" as it pays no income and has no earnings. So, it is impossible to ever say whether gold is "cheap" or "expensive." All we can say is that gold has been in a raging bull market for over a decade, and that its price action is starting to look like a lot of other financial bubbles we've seen in the past.
If you missed out on gold's recent gains, you're probably kicking yourself. Don't. Once the dust settles, it is likely to be the gold bugs who are kicking themselves. I recommend avoiding gold, but more adventurous traders might want to short it, like Treasuries, in the futures market or using an inverse fund like the PowerShares DB Double Short Gold Fund (DZZ)
Use this as an opportunity to buy some of the solid blue chips you've been itching to buy "if only they were a little cheaper." I recommend American and European companies with rock-solid balance sheets, consistent dividends, and a large presence in emerging markets. These are the kinds of companies that you know will survive this mess intact. If you end up being a little early, what of it? If you buy a good company at a good price, a little short term volatility is nothing to be afraid of.
I should mention that Microsoft and Johnson & Johnson now have a higher credit rating than the United States of America!
I understand that it is scary out there. But it is times like this when an investor can differentiate him or herself by taking a bold, contrarian stand. Use the current mood of hysteria to your advantage. Sell down your expensive bond and gold holdings and reallocate your funds where you can find real, durable value.
Charles Lewis Sizemore, CFA