Investors felt a chill when Standard & Poor’s recently downgraded its outlook on the AAA-rated debt of the U.S. to “negative” from stable. Yet credit investors never blinked an eye.
As one veteran debt analyst pointed out, “Stock investors panicked about the prospect of the credit boom ending, yet the people responsible for the credit boom had no reaction!”
Equity investors’ concerns do have some merit, as the U.S. has created a structural budget deficit of epic proportions. But it’s already been 30 months since the government announced it would go deeply into the red to finance a stimulus. And the rating agency just noticed?
Credit investors’ insouciance may be counter-intuitive, but it makes sense if you understand their role in this cycle. They are so desperate for yield that they will lever up and buy anything and everything with a coupon until they get hit with margin calls. Since we are early in this process, according to the credit analysts I follow, margin calls are unlikely for two to five years.
Bonds have progressed so much more smoothly during all the quake and North African troubles because credit investors have been chill and professional about buying steadily in all conditions, while stock investors have been manic.
Chief investment officers at pension funds are focused on making 7.5% to 8% annual gains in credit, and an S&P outlook change will not stop them. Consider that just in the past several weeks, some states announced pension funding gaps of more than 25%, growing by more than $1 billion over prior estimates. Pension fund managers are responsible for hitting their marks to make sure retirees get what they are owed, and they will move heaven and earth to do it or face the loss of their jobs.
Another example of what they face: The Texas teachers’ pension fund needs to earn 21% over the rest of the year just to maintain its underfunding at 20%. They would have to buy 1% bonds at a leverage of 20x to hit that mark, so you can see why an outlook change is not even on their radar.
The upshot is that bond prices are going to remain firm, both in the government, investment-grade and junk realms, as funds play catch-up after their massive losses of 2007-2008. And as long as that is true, all dips in the stock market will be resolved to the upside because corporate leaders will leverage the credit market to get their stock prices up via mergers and buybacks.
You can be sure that this will end badly after the credit boom has run out of steam, but probably not for another two to five years — which is much longer than most equity investors expect.
Moreover, I am probably more skeptical about the quality of Standard & Poor’s work than most people after studying the organization for a long time.
I first started taking a close look at S&P in the late 1990s and early 2000s, when I realized that they were becoming the most important fund manager in the world. The reason: The S&P 500 Index that it had developed to track the 500 most representative companies in the U.S. had been crowned by a set of renegade financial professors and investment consultants as the ideal vehicle for large-scale investment in U.S. stocks.
The “passive” index investment concept started as a fad, and it caught hold because the late 1990s were the ideal time for that particular style of investing. The index was driven higher by large-cap technology, finance and pharmaceutical stocks, and it became very easy for pension fund managers to abdicate their stock-picking responsibilities to the index. Ultimately, more than a trillion dollars has been invested in this concept.
What most people did not realize was that the S&P committee focused on choosing the stocks that went into the index was not comprised of experienced fund managers or investment professionals. It was headed by some old-school, ivory-tower economists, and had several marketing and PR people as well. Their main aim was to make a famous index that would generate lots of licensing fees for S&P– not just to create a create a great investment vehicle — and that goal led them to make a lot of choices that ended up being very harmful.
Without going into a lot of detail, what ended up happening was that the S&P 500 Index committee in the late 1990s got caught up in the tech-stock, “new paradigm” fever and started to actively remove many good, strong, well-seasoned value stocks from the list and replace them with tech darlings. The people in charge of this supposedly “passive” index were acting just like the dumbest active managers, removing valuable companies crazy little flash-in-the-pan techs like BroadVision, Global Crossing, Gateway Computer and Conexant (NASDAQ:CNXT) near their peaks, many of which have disappeared.
I wrote a series of columns highlighting this problem which won a lot of awards, and S&P settled down to become less active with the index in the mid-2000s. But then the company resurfaced in the 2005-2007 era as one of the debt-rating organizations that completely dropped the ball on judging the merits of very iffy mortgage derivatives, giving AAA ratings to debt instruments that later completely blew up. It has taken a lot of heat for those mistakes, but still motors on.
So, now S&P is supposedly this neutral third-party judging the value of U.S. debt. Well maybe they have gotten the religion and finally deserve respect, but the initial reaction of the markets to its call on said it all: Stock investors took equities down hard with a knee-jerk reaction, but investors in U.S. government securities actually bought more of them — rocketing Treasurys to new multimonth highs.
That was a pretty interesting reaction to securities that S&P said might not return principal in two years — the biggest danger of all for bond investors. Maybe the bond people know something that the equity people don’t. It would not be the first time.
In short, much of what S&P said about U.S. debt is true, but most experienced investors have understood the risks for some time, and many would actually tell you that current prices already discount that point of view. Now let’s hope that Congress and the White House have finally gotten the message, and will come to an agreement in coming years on making the undeniably painful choices that lie ahead in rationalizing the federal budget and cutting the deficit.
For more guidance like this, check out Markman’s daily trading service, Trader’s Advantage, or his long-term investment service, Strategic Advantage