Now What?

Today we entered uncharted territory. For first time, the U.S. suffered a credit downgrade and is no longer AAA, according to S&P. So now what?

Some will say it isn’t a big deal. What’s one notch to AA+? The problem with that thinking is that it assumes we don’t go lower than AA+. But the problems that brought us here aren’t solved, not by a long shot. In fact, they haven’t been addressed at all. So one has to reasonably assume the step to AA+ is just the first step in a long slide to greater depths. That is a big deal.

To some extent, the rating agencies are a lagging indicator. It’s not as if the debt and deficits were any great secret. And the market rendered its judgment on Washington’s deal in last week’s sell-off. (It’s also a wonder the ratings agencies have any influence at all, given their complete failure during the mortgage crisis to anticipate anything.)

The loss of AAA is psychologically important. It’s symbolical. But it also will set in motion a series of events. Some institutions can hold only AAA-rated debt. So they will have to amend their charters or sell U.S. debt. Also, across the economy, interest rates are set from the baseline of U.S. Treasuries. So if the downgrade means interest rates tick up a few notches, it will create a ripple effect across the economy. That means another credit squeeze at a time when the economy is already weak.

People complain that U.S. companies are hoarding cash, not investing and creating jobs. The impact of recent days will only make that trend stronger. Already, a Wall Street Journal headline reads, “Firms Look to Raise Cash as Volatility Rises.” Who will want to build businesses and risk capital in this environment? Fewer than might otherwise, that’s for sure.

As I say, we’re in a new world. Lots of strange and weird things are happening. Consider a few…

JPMorgan Chase started paying homeowners to stay in their homes, rather than go into foreclosure. How one deal worked: The lender offered to forgive $100,000 in mortgage debt and give the borrower $10,000 in cash at closing if they stayed in the house and facilitated a sale. In this way, the lender avoids foreclosure costs and a big haircut on the loan. (Abandoned homes are tough sells without a big price cut.) The bank loses less. Strange times.

Also strange: The Bank of New York Mellon started charging its big clients to hold deposits. You know, usually the bank pays you interest on a deposit. Well, with all the turmoil, Mellon found itself awash in deposits as people fled to the safety of cash. Deposits for a bank are a liability. Banks loan it out, but if they don’t have demand for good loans, it costs the bank money to hold deposits. So Mellon implemented the 0.13% charge.

And finally, from Rhode Island, the city of Central Falls declared bankruptcy. State officials tried to persuade retirees to accept voluntary cuts in their benefits. They said no. So the city declared bankruptcy. Now the retirees will probably get much less than they were offered in the compromise. This is going to be a big problem across cities and states nationwide. Central Falls is the canary in the coal mine.

Of course, I haven’t even said a word about the EU. It has the same problems as the U.S. — even worse. So the ECB — Europe’s central bank — announced it’s going to start buying Italy’s and Spain’s debts to help prop up the flagging finances of both. As in the U.S., its politicians can’t deal with the problem. No one seems to have the stomach to make real cuts on either side of the Atlantic. So these problems get kicked down the road a bit, but not solved.

So as I asked up top, now what?

Let me start by saying: Don’t panic. As Horizon Asset Management noted in their second-quarter commentary:

Perceived risk and real risk are very different phenomena, and even where a real risk exists, the common reaction, powerfully motivated by our sociobiological heritage — to flee — is often the incorrect one. This is because the financial markets are a social system, not an ordered, fixed system — a market — such that whatever equation might be true in one moment immediately induces reactions and counter-reactions among the other participants, and these reactions change the equation.

As I wrote last week, the urge to do something is powerful, but should be resisted. Undoubtedly, prices today reflect a lot of fear. That’s not to say we’re at a bottom. But I can say without a doubt that there are stocks here today that in a year or two, you will wish you had bought. It’s the way markets go. The market is a mirror of emotions. It’s not coldly rational. That explains the wild swings.

There are also few investors left anymore, it seems. Everyone is a trader. In the last issue of Grant’s Interest Rate Observer, Jim Grant writes about one of the long-term trends I find most fascinating in markets and have written about before: the decline of holding periods. At the end of World War II, investors held stocks for an average of four years. By 2000, it had shrunk to only eight months. “In the absence of current data,” Grants writes, “we will have to speculate about 2011. Our best guess is about 20 minutes.

“In such a climate of fear and short-term views, there is bound to be opportunity for those with cool nerves and patience. In fact, this is one of the individual investor’s greatest advantages: the ability to sit on his hands.

As an individual investor, you don’t have to report to anyone. (Except maybe your spouse. Heh.) So you don’t have to engage in window dressing to make your portfolio look good at the end of a quarter. You don’t have to explain your every move weekly to clients. You can look past the quarterly earnings reports. These things make a difference.

Grant quotes Shad Rowe, who runs a long-only fund at Greenbrier Partners. “Time trumps information,” Rowe says. “Time is the only edge that an individual investor has.”

Rowe goes on to talk about a friend who hates the market because he feels like he is at a big disadvantage as far information goes. The professionals know more, have access to better research and inside tips and do due diligence above and beyond what the armchair investor can do. “And the truth is, in the short term, he is absolutely right,” Rowe says. “On the other hand, this individual does have one great advantage — time.”

Bill Miller at Legg Mason called it “time arbitrage.” The idea is simply that in a world where so many have such a short-term view, you can do well looking even a year out.


Chris Mayer,
for The Daily Reckoning