U.S. Downgraded: What to Do Now

by: Nigam Arora

Standard & Poor’s (S&P) has just downgraded U.S. credit rating to AA+ from AAA. S&P analysis can be found here.

S&P Analysis

Here is an overview of the analysis by S&P:

  • We have lowered our long-term sovereign credit rating on the UnitedStates of America to 'AA+' from ' AAA' and affirmed the 'A-1+' short-term rating.
  • We have also removed both the short- and long-term ratings fromCreditWatch negative.
  • The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.
  • More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.
  • Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon.
  • The outlook on the long-term rating is negative. We could lower the long-term rating to 'AA' within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.

Our Analysis

There will be no shortage of opinions in the media on the downgrade. The problem is that the vast majority of the opinions do not make money for the investors. I am refraining from writing my opinion; instead I am focusing on helping investors make money.

This downgrade is a major change. The best way I know to profit from change is to apply the ZYX Change Method.

Markets move based on the difference between expectations and what actually occurs. The first task is to determine how the street is positioned. ‘The street’ is simply a term that means positions of a majority of the big players. Obviously the big players do not disclose their positions; as a matter of fact, they guard them closely. However, the analysis is easy because of the data available from the computers at The Arora Report. The algorithms we use monitor and dissect every tick to generate valuable insights.

Following are our conclusions:

o Regarding stocks, about 70% of the street is already positioned for a downgrade.

o Regarding stocks, about 40% of the street is positioned for a downgrade to AA.

o Actual downgrade is not to AA, but to AA+.

o The net effect of the downgrade being less than what was expected by some and surprise to about 30% of market participants is likely to be a wash.

  • At the first glance, it would seem that the U.S. treasury bonds, now with a lower rating, should fall. But in reality, the opposite is a possibility. The reason is that a downgrade will provide more momentum to fiscal austerity in Washington. Fiscal austerity in the short-term means a slower economy. Slower economy means higher bonds.
  • There has been a big concern about a large amount of treasuries held by big U.S. banks. The Federal Reserve Bank has just come out with a statement that it will tell member banks there is no change in the risk weighting of the U.S. treasuries. In essence, this statement means that the Federal Reserve is spanking S&P.
  • It is hard to imagine France with a rating higher than the U.S.
  • It is hard to imagine the European Central Bank with a rating higher than the Federal Reserve.
  • This downgrade is likely to start of a race to the bottom, i.e., we may see a number of downgrades on an international basis.
  • Since Moody’s and Fitch have reaffirmed AAA rating of the U.S., in material terms, this downgrade will have no effect on institutions required to hold AAA paper. By law, institutions are allowed to use the highest available rating.

What to do now?

o If stocks get hit, we will be buyers of ETFs SPY and QQQ.

o If gold and silver spike up, we will short sell ETFs GLD and SLV or buy ZSL

o We will take the opposite side of the first move in U.S. treasuries. We will use the ETFs TBT, TBF, and TLT.

For additional insights and investment opportunities, please see Market Pricing In Armageddon: Positioning Ourselves for Returns , Debt Ceiling Agreement: Short Selling Silver Again, Debt Ceiling: What Traders Should Do Now, and 5 Bargains to Buy on Any Debt Default Dip .

Disclosure: I am long QQQ, TBF.

Additional disclosure: I am short TLT and silver futures. I have just taken profits on my very recent short SLV position.