As S&P downgraded U.S. debt, markets plunged and volatility soared. Although there is no question that a reduction of the credit quality of a debtor is typically concerning, there may be an unexpected positive secondary effect in the case of the U.S. Although the market bounced back from its lows recently, the market remains nervous and volatile, and such a positive effect has yet to materialize in a sustainable manner.
First, if one is to interpret the recent downgrade as a possibility that the U.S. may default, then the long-term held view that U.S. Treasury yields are synonymous of the Risk Free Rate no longer holds. Naturally, that means that the Risk Free Rate is lower than U.S. Treasury yields. In such a case, P/E ratios can expand, leading to higher stock valuations and an increase in investments.
Second, the U.S. Treasury market has absorbed over $12 trillion in investments to date. As it seems such investments are no longer risk free, then investors should be willing now to channel some of that money into high grade corporate bonds, and possibly, high quality/ high dividend yielding equities. This will boost private investments, which will create additional jobs, as opposed to the inefficient use of such funds by the government.
Third, this could finally trigger profitable corporations to invest their massive cash hoards in a productive manner, as opposed to "No Longer Risk Free Treasuries." Apple (AAPL) alone has a "cash & liquid securities" hoard of about $76 billion. Google (GOOG) has about $39 billion. Microsoft (MSFT) has about $43 billion after the Skype purchase. It is estimated that the largest corporations have combined cash hoards in excess of $1 trillion. Investment of such cash will lead to job creation, a boost to the economy, and an appreciation in the stock market.
Fourth, it is possible that such downgrade will ultimately result in a lower dollar. In such case, U.S. products and services will become more competitive internationally. Furthermore, international sales of U.S. companies will translate into higher dollar denominated sales. This will boost revenues and profits, which will lead to higher equity prices.
Fifth, the Federal Reserve will most likely remain in an accommodative stand in order to offset the initial impact of the downgrade. At its most recent meeting, the Federal Reserve confirmed that it would maintain its current historical low rates until 2013. It may even go further by announcing another measure of quantitative easing if needed, as was alluded to in the press release. This will provide additional liquidity to the markets and will ultimately boost credit, jobs, the economy and the stock market.
Once the dust settles and the initial shock is overcome, the economy and the stock market may surprise us all with a sustainable move to the upside.
Additional disclosure: Please note that I mentioned some of these points in a comment posted yesterday only on Seeking Alpha, but decided to formalize it as a complete article.