Last week was the worst week in the U.S. financial markets since the financial crisis of 2008. The Dow and the S&P 500 each declined approximately 10% over the last 6 trading days. On last Thursday, August 4, 2011 markets declined just under 5% in a single day. The reasons: various! European debt default issues, fear the European Union and the currency will collapse, the US Debt ceiling and subsequent fiscal and political debacle that kept American and the world on the edge of its seat for days. Basically, the entire western world is over-leveraged and we are yet again feeling the effects of a debt-party hangover.
2 Big things to consider this morning and over the coming weeks:
1) On last Friday night, August 5, 2011, rating agency Standard & Poors (S&P) downgraded the U.S. government’s credit rating to AA+, down one-notch from AAA. In other words, S&P no longer believes that the U.S. will be able to meet all of its financial obligations without a shadow of a doubt. The implications will likely be higher interest rates, which will simply exasperate the problem by increasing the debt and interest payments U.S. needs to make to its creditors. In addition, Municipal securities issued by states and local governments will become under fire as well. Think about it: how can a township, city or state within the U.S. have a better credit rating the U.S. itself? The answer: It can’t.
Why? A chain reaction of credit rating downgrades. S&P is expected to downgrade hundreds municipal securities based on the premise I described above. Simulatenously, Investors such as pension funds, sovereign wealth funds, mutual and money markets, etc… are reviewing their investment mandates and other important documentation to determine if they will be forced to sell municipal securities. Within their detailed investment guidelines there are fine points describing which securities these investment vehicles are able to hold; these securities are known as ”permitted investments”. Some will require municipal securities and U.S. treasuries to be rated AAA. But what happens if the rating agency Moody’s believes these securities are still Aaa and S&P does not? That is what these investors will need to determine. Since S&P has downgraded the U.S. but the other two big rating agencies have not , expect to see volatility in the municipal securities market. If there are forced sellers in the market expect a pricing impact.
2) MORE political drama: The longer the U.S. political “leaders” drag their feet delaying the balancing of the budget we will continue to see investors acting out of fear and pressure in the market. The U.S. has over $14 trillion in debt and the U.S. GDP is approximately $14 trillion as well, meaning that the U.S. Debt-to-GDP ratio is 100% and just under 4% of our GDP is earmarked for interest payments.
The questions that investors are deeply concerned about are: How will the government decrease spending and increase taxes to pay down our massive debt and at the same time launch new programs to create jobs? A quick fix or another round of Quantitative Easing (QE3) is simply not possible given our financial position.
In addition, corporate earnings are reasonably strong thus far in 2011 (approximately 18% in earnings of S&P 500 stocks through June 2011), however the unemployment rate remains over 9%. The question we need to ask is: How long can corporate earnings continue to improve if: 1) Corporations are not willing to make new investments and focus on research and development, which would increase hiring and create new jobs? 2) If Corporate tax rates are increased then there will be less cash flow available for investments and if personal tax rates are increased there will be less disposable income for consumers to spend on consuming. In this scenario the U.S. debt overload becomes a circular-issue, a self-fulfilling prophesy, which drives the thought process of investors with both short-term and long-term goals.
The take-away: The fear will not subside quickly, therefore a “quick fix” for your investment portfolio is not a viable solution.
A few ideas:
- Do not do anything rash; discuss your options with your financial advisor.
- Question your advisors logic, make sure he/she understands the issues and can back-up why they are taking action or staying put
- Be prepared for further volatility and tough days. Markets go up and down and sideways, just like life. We happen to be in one of those ugly down times, it won’t last forever, even though it feels like it will while you are in it.
- If you are buying securities, do your homework. May sure you understand the company or the financial product and expect that you may buy and experience losses right away given the climate.
- Review your cash position. Have enough cash so that you can sleep at night and know that you can live for several months (6 to 12 months at a minimum) if you lose your job or your income.
- Pay down debt in lieu of investing. The return is better (for now) and you will be reducing your month expenses.
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