Debt Downgrade News Impacts Stocks More Than Debt Itself

|
Includes: DIA, QQQ, SPY
by: Investment U

By Justin Dove

When the S&P downgraded U.S. debt last Friday, it implied that government debt was more risky. But the U.S. Treasury markets are seemingly laughing in S&P’s face. The debt downgrade was undoubtedly the catalyst for stock markets tanking almost four percent within an hour on Monday morning. But it also led to a buying spree of these so-called “riskier” Treasury instruments. Two-year Treasury yields fell to record lows. Ten-year Treasuries are selling at the highest prices since November of 2010. Take that S&P.

S&P Lacks Credibility

This is a sign that investors still consider U.S. Treasuries as a safe haven. As Marc Lichtenfeld pointed out last week, the bond ratings agencies such as S&P lack credibility and carry too much influence. Mohamed El-Erian also made an excellent point in his editorial for the Financial Times:

“The future role of rating agencies will also now come under close scrutiny, bringing to the fore the question of who rates the rating agencies? S&P’s action will likely unite governments in America and Europe in an effort to erode their monopoly power and operational influence.”

The White House and others can debate S&P’s choice to downgrade U.S. debt for as long as they’d like. However, no one can argue the effects that this simple report is having on investors.

The Snowball Effect of Panic Selling

The largest effect of the rating decrease seems to be how the stock markets have reacted to the news. The Dow, S&P 500 and Nasdaq all continued freefalling on the heels of the debt downgrade.

But no companies have reported any major changes in earnings. There are no fundamental flaws that investors are selling on. Thus, it’s obvious that this is a panic sell-off. Emotions such as fear are causing people to sell at all costs. It’s a snowball effect.

  • The initial fear causes some investors to sell.
  • Then this initial drop scares other investors who feel they need to get out before there are more losses.

Their actions in turn create more losses and things spiral out of control.

Much Ado About Nothing

Now, there are certainly some things in our world to be fearful of, but the S&P downgrade isn’t one of them.

  • As Paul R. La Monica wrote for the CNNMoney blog, “S&P has made it no secret that its downgrade is more about politics and less about the actual health of the credit markets.” The Federal Reserve still has the power to print money. There was never really a possibility that the United States would default on anything. As Jason Jenkins recently wrote, the United States isn’t Greece.
  • Bloomberg reported that Wall Street doesn’t think the ratings cut is a big deal. According to the article, Barclays PLC (NYSE: BCS) claims the downgrade shouldn’t be “significant.” Obviously the bigger issues are slowing growth and the Eurozone debt crisis. But even those factors are still fears of future problems rather than the actual problems.
  • Ratings agencies Moody’s and Fitch still haven’t downgraded U.S. debt. As long as those ratings remain AAA, the U.S. debt is still considered AAA by institutional investors. That means there shouldn’t be a flood of U.S. Treasuries on the market by institutions, which must keep a certain percentage of AAA debt on the books.

Step Away From the Ledge

The world economies certainly aren’t booming. But there shouldn’t be this much fear in the stock market. Many investors seem to be following the ups and downs of the news. It’s the only way to explain the emotionally driven roller coaster we’ve seen recently.

Most successful investors don’t pay too much attention to the news for this reason. It’s useless trying to time every little hiccup in the market. Historically, the best days in the market are following the biggest bouts of panic selling, such as the Great Depression and the Great Recession. If you miss those, it could certainly hurt your earnings.

The downgrade didn’t cause the sky to implode. It didn’t even cause Treasury rates to balloon. But the news has created panic in the stock markets around the world. Don’t let it scare you away, too. Take the long-term view and try not to be driven by fear.

Disclosure: Investment U expressly forbids its writers from having a financial interest in any security they recommend to our subscribers. All employees and agents of Investment U (and affiliated companies) must wait 24 hours after an initial trade recommendation is published on online - or 72 hours after a direct mail publication is sent - before acting on that recommendation.