S&P Downgrade Costs Investors $1 Trillion

Shareholders in American companies can blame Standard & Poor’s  for taking $1 trillion of their money after the rating firm downgraded Treasury securities for the first time in American history to AA+ from AAA.  Now, some of the most experienced investors say the stock market losses make no sense.  While the benchmark index for U.S. equities fell as much as 6.7 percent — or $1.03 trillion — since the downgrade, 10-year Treasuries rallied the most in more than two years and the government financed its quarterly debt obligations at the lowest interest rates ever.  Treasuries have returned two percent since the downgrade.

“One of the most perverse things I’ve seen in 25 years of doing this is that S&P downgrades the United States government, and investors’ reaction is to run towards the securities that they downgrade, selling businesses without asking at what price,” said Kevin Rendino, a money manager at BlackRock Inc., which oversees $3.65 trillion.  “Equity prices have swung too far.”

The downgrade, which diverged from Moody’s Investors Service and Fitch Ratings, turned investors’ focus from the 10^th consecutive quarter in which S&P 500 companies topped analyst earnings forecasts.  Per-share profits had climbed 18 percent among companies in the index, with 76 percent topping the average analyst projection, according to data compiled by Bloomberg.  Sales grew by 13 percent.

“It did a lot of damage to confidence, which had been shaky anyway,” Liz Ann Sonders, New York-based chief investment strategist at Charles Schwab, said.  “We had started to get a sense of a little bit of a lift for the economy in the second half of the year, and you just kind of wiped it out because of the lack of confidence in our political leaders. S&P reflected that with the downgrade, but what it ended up causing was a real confidence crisis, more than an economic crisis.”

Additionally, the Chicago Board Options Exchange volatility index jumped 50 per cent to 48, the highest level in 29 months and the biggest jump in more than four years, the first trading day after the downgrade was announced.

“We’re starting to see real disorderly selling, far more than what we’ve been seeing,” said Matthew Peron, head of active equities at the Chicago-based Northern Trust, which manages approximately $650 billion in assets.  At Jersey City-based Knight Capital, senior equity trader Joseph Mazzella said that “It’s scary.  It really is.  I hate it when the market closes below its low, as it sets the stocks up for a follow-through tomorrow.”

President Barack Obama said that he blames political gridlock in Washington, D.C., for the downgrade.  He announced plans to offer recommendations on ways to cut the federal deficit.  Agreeing with the president is William Suplee, a financial manager with Structured Asset Management in Paoli, PA.  “Almost universally my clients are blaming this on ‘The Government’, this lack of confidence – and that is what it is.  This sell-off is uniformly blamed by my clients on the government’s inability to act rationally.

According to Genna R. Miller, Ph.D., Visiting Instructor, Economics Department, Duke University, “In terms of the CPA profession, there may have been some fear that the negative outlook on U.S. sovereign debt, as well as possible increases in interest rates, may have caused a further downturn in the economy.  Such a downturn in the economy may have been expected to reduce the demand for accounting services, as clients’ incomes declined.  However, as there have only, at this point in time, been minimal impacts on the economy and the accounting profession, this does not appear to be the case.  It may be the case that the income elasticity of demand for accounting services may actually be quite inelastic.  The income elasticity of demand tells us the percentage change in quantity demanded for accounting services divided by the percentage change in clients’ incomes.  Thus, if there is a relatively inelastic income elasticity of demand, then clients who have had accounting services in the past may continue to do so, despite any declines in their own income.  On the flip side, some financial planners may have experienced an increase in business as some clients may have needed to re-assess portfolio values from a tax perspective or may have needed to comply with disclosure policies with respect to increased risk.”

Mark Vitner, Managing Director & Senior Economist, Wells Fargo Securities, LLC, offers this perspective.  “I think most firms understand that the downgrade does not affect many private businesses.  The downgrade and the problems with the federal budget deficit that precipitated it are primarily a problem for state and local governments and government contractors.  Businesses and governments that receive a large part of their funding from the federal government will be most impacted by the downgrade and renewed emphasis on deficit reduction.”

Rick Mattoon of the Fed believes the downgrade will affect mostly the secondary markets like municipals funds.  Listen to his podcast here.