S&P Debt Downgrade: Could This Spark a Major Relief Rally?

Includes: F, GS, HPQ, MGM, RCL, UAL
by: Rougemont
Finally, S&P delivers the highly anticipated news that it has downgraded the U.S. credit rating to AA+. Now we can remove one more overhang from the market.
There are a number of solid reasons why this "event" might not have much further negative impact on the markets and that it could even help spark a major rally. The downgrade is likely to have more political significance than any impact on the markets going forward because the markets have been anticipating this event for weeks. There is no doubt that many shorts were putting bets on this in the past few weeks and that many investors were selling. It's also likely that many top investment banks and others with strong Wall Street connections knew that S&P would officially announce the downgrade on Friday. That would explain the very heavy losses in the markets on Thursday of about 513 points on the Dow index.
This is important because it raises the likelihood that the downgrade is already priced into the market. In fact, it could be more than priced in by now. On Monday, a strong rally by the end of the day or a muted stock market reaction is very probable. I think the news coming from Europe is much more important than the downgrade on the markets. The downgrade will be used for political purposes and it is a humbling moment for the United States. But that's about it at this point, as the market has already seen a significant correction. Markets could be relieved that the downgrade has now happened as this lifts one more overhang from the list of worries that caused the markets to sharply sell off.
Fortunately, people have the weekend to see that in spite of a one notch downgrade, coming from a ratings agency with a questionable track record, there are still people flying on planes, going to the movies, eating at restaurants, and shopping. The world is going to continue, just as it always has, and just as it has in Japan and other countries after they were downgraded.
Let's go further into why the markets should be able to withstand this not so unexpected news, and perhaps even rally this week:
First, it is important to look at the track record of Standard & Poor's. Many seriously doubt the credibility of this and other ratings agencies as they were rating highly toxic mortgage securities a AAA rating, when they clearly were not. With that kind of track record many believe their own analysis is better than what is put out by S&P. It's important to remember that this is just an opinion coming from just one agency that doesn't have a perfect track record by any means.
Another big factor to consider is the White House and the Treasury Department believe that S&P made an error in the analysis that totals about $2 trillion. Furthermore, Moody's and Fitch Ratings recently affirmed the AAA rating of the U.S., and often in the ratings world when one agency gives a different rating this is called a split rating and the higher rating is generally accepted by the markets. With two of the three ratings agencies still affirming a AAA credit rating and investors still buying U.S. Treasury bonds for safety, the actions of S&P are not the end all. Read more about the rating from Moody's and Fitch and the analysis errors believed to be made by S&P here.
It is important to look at history when trying to evaluate the impact a downgrade has on the markets. S&P downgraded the debt rating for Japan around January of 2011, and it had negligible effect on the stock market or economy in Japan. The downgrade also did little to the interest rates in Japan and Japanese bonds still have some of the lowest interest rates in the world. Read that story here.
The investors around the world have the most important ratings opinion and they are clearly giving U.S. debt the highest ratings possible because yields are falling and investors are rushing to the safety of U.S. Treasury debt, especially in the wake of weak stock markets for the past two weeks.
The fact that global investors seek the safety of U.S. Treasury bonds when world markets are in turmoil is a significant sign that the ratings given by investors to the United States is the highest. If you think about when papers are graded on a curve in school, that situation very much applies now. After a huge financial crisis and a global recession, most major countries have strained their balance sheets - that is what happens when major recessions hit. Our classroom is the world, and in spite of the world economy and global government finances not being what they were before the recession, the fact remains that investors still believe the United States is the "best student in the class" and therefore one of the safest places to invest.
The S&P downgrade is not likely to change that anytime soon. The reality is the entire world economy has been downgraded and on a relative basis the U.S. is one of the best and safest places.
Here are reasons why the markets could significantly rally after digesting the downgrade news:
1. There is a saying that goes "buy on the rumor and sell on the news." The buy on the rumor applies when investors believe good news is likely from a company. Because of this expectation, investors start buying before the news is confirmed and the shares rise before the news is confirmed. However, many investors are surprised when stocks often fall the same day the good news is confirmed. This happens because the markets have already priced in the good news and when the stock fails to rise any further, investors cash in and move on.
In this case, the markets have been expecting negative news, which is the downgrade of U.S. debt, so we have to consider the opposite whereby investors have been selling stocks and shorts have been actively shorting the markets in anticipation of a U.S. debt downgrade. Now that the downgrade has happened, we could see the reverse effect in which investors start buying stocks because they no longer have a possible downgrade hanging over them and because shorts cover their positions since the markets have already priced in the bad news.
The downgrade is very likely to be yawned at by the market after having so much time to anticipate it and also because it's no real surprise, especially with the debt ceiling debate in Congress being televised daily for the past few weeks. A new CNBC article states: "Marc Pado, Cantor Fitzgerald market strategist, said it may be that stocks will take the news better than some might expect because the market has been reacting to the potential downgrade by one or more notches for the past two weeks." Read that here.
2. The markets are cheap and deeply oversold. Jin Najarian from CNBC's Fast Money states a massive short squeeze is likely to drive the next move in the markets. Late on Friday, the European Central Bank (ECB) said it would start buying Italian bonds on Monday. That positive news, plus the signs of a capitulation sell off in the stock market on Thursday, led Najarian to say: “Bulls needed to see blowout volume. They got that. They needed to see a massive sell-off. The market was down triple digits. All the pieces are coming together. Investors might be nervous into the close but it might be nervous shorts for a change." Read more on Najarian call for a massive short squeeze here.
3. A market indicator with a perfect record for the past 20 years just signaled it's time to buy stocks. A new CNBC article states that technical analyst John Roque said, "In a note to clients, Roque pointed out that the number of NYSE stocks above their 200-day average on the NYSE was a measly 19%. When the number of stocks that manage to stay above this moving average - a common measure of momentum - makes a nasty two standard deviation move to the downside from the norm, it usually means an oversold market and a good time to buy." The article goes on to say: "Two weeks and three months later, the S&P 500 has been positive every time hitting the oversold trigger, with gains averaging 5.3% and 15%, respectively. The last - and most extreme - oversold position was on March 2, 2009, about around the start of the bull market." Read that here.
4. Top hedge funds believe there is a 60% chance of QE3 stimulus: According to a new CNBC article, top hedge fund manager Anthony Scaramucci believes that "after extensive conversations with peers, analysts at Skybridge are now predicting as great as a 60% likelihood that the Fed implements QE3.
5. The price of oil has come down sharply and is back in the $80 range in the midst of all this negativity. Lower oil is great news for the U.S. economy and it has the same effect as a stimulus program would have. Consumers will have more money for retail goods, vacations, etc., and businesses will see lower manufacturing and shipping costs. Lower oil is a massive stimulus program for the U.S economy.
Based on all if this, it will probably pay to start buying stocks, especially on any more dips as the next big move is likely to be up. Here are some stocks that could benefit nicely from a "massive short squeeze" in the markets:
Goldman Sachs (NYSE:GS) shares are trading at $125.18. Goldman Sachs is a major investment banking company based in New York. The 50-day moving average is about $133.67 and the 200-day moving average is $153.86. Earnings estimates for GS are $11.29 per share in 2011 and $16.83 for 2012.
MGM Resorts (NYSE:MGM) shares are trading at $12.66. MGM is a major hotel and casino company based in Las Vegas. The 50-day moving average is $13.95 and the 200-day moving average is $13.81. Earnings estimates for MGM are for a loss of about 62 cents per share in 2011. Consumers are far more likely to feel comfortable enough to vacation in Las Vegas when they don't have to spend so much filling their tanks.
United Continental Holdings (NYSE:UAL) shares are trading at $16.82. United is a major global airline. The 50-day moving average is $21.60 and the 200-day moving average is $24.25. UAL is estimated to earn about $3.58 per share in 2011 and $4.89 in 2012. This puts the PE ratio at just over 5. Book value is listed at $5.27 per share. Fuel costs are a major expense for any airline, and with a sharp drop in oil UAL will see lower expenses.
Royal Caribbean Cruises (NYSE:RCL) shares are trading at $27. RCL is a major cruise line company. The 50-day moving average is $35.24 and the 200-day moving average is $40.83. Earnings estimates for RCL are for a profit of about $3.25 cents per share in 2011 and $3.88 in 2012. Just as with airlines, fuel costs are a major expense for cruise lines. Lower fuel costs means better profit margins and more bookings.
Ford Motor Co. (NYSE:F) shares are trading at $10.84. The 50-day moving average is about $13.26 and the 200-day moving average is about $15.17, so these shares are trading well below support levels. Ford shares hit a 52-week high of $18.97 earlier this year. Earnings estimates for F are $1.97 per share in 2011 and $2 for 2012 which puts the PE ratio at about 5.5.
Hewlett Packard (NYSE:HPQ) shares are trading at $32.63. HPQ is a leading technology company with products ranging from computers to printers. The 50-day moving average is about $35.54 and the 200-day moving average is about $40.79. The earnings estimates for HPQ are just over $5 per share in 2011 and $5.37 for 2012. HPQ pays a dividend of 48 cents per year, which is equivalent to a 1.5% yield.
The data is sourced from Yahoo Finance and Stockcharts.com. The information and data is believed to be accurate, but no guarantees or representations are made. Rougemont is not a registered investment advisor and does not provide specific investment advice. This information is solely educational in nature and not intended to serve as the basis for any investment decision.
Disclosure: I am long UAL, HPQ.
Additional disclosure: I may buy all of these stocks soon.