Free Markets, Free People

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The first post-downgrade business day

The yield on the 10-year note has dropped to 2.44%, down from 2.57% at Friday’s close. I’m thinking this is telling us the economy’s on the way into the toilet, as the standard reaction for a credit downgrade is rising interest rates, to cover the extra risk. The Dow’s long slide, which began on 22 July–and continues with a 250 point loss so far today–is probably telling us the same thing, as earning expectations slide. Since the downgrade was one agency only, and the downgrade only to AA+, economic factors are clearly weighing more on the bonds than the downgrade.  On the other hand, if you’re a gold investor, you’re probably a little happier today, as Gold hit $1,715/oz.

The key takeaway so far today is the continuing decline in yields, which isn’t good news. Thank goodness there’s no economic releases today. I’d hate to see what more bad news would bring.

So, back into recession, it looks like.

One of the more interesting things I’m wondering about, in a horrified kind of way, is what effect the downgrade has on corporate paper.  A number of institutions have investment rules that require they concentrate their investments in AAA-rated securities.  But, one of the general rating rules is that subsidiary corporate and government instruments cannot have a higher rating than their sovereign instruments. So if the US Government doesn’t have a AAA rating, no subsidiary US corporate or government paper should have a AAA rating either.

So, what does this mean for the handful of corporate and government instruments that were rated AAA prior to the downgrade? Do they get downgraded, too?  If so, where do the institutions with a AAA rating requirement go with their money?

I’m not at all sure how this works. As we’ve been saying a lot in the last week or so, we’re in uncharted territory.

END OF DAY WRAP-UP: Well, that could’ve been worse, I suppose.

INDEX Close
Dow 10,810.83 -634.76 (-5.55%)
S&P 500 1,119.46 -79.92 (-6.66%)
NASDAQ 2,357,69 -174.72 (-6.90%)
10-Year Yield 2.34% -0.22%
Comex Gold $1,710.20/oz (+3.7%)

I’m not sure how much worse it could’ve been, though.

~
Dale Franks
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The Shape of Things to Come

It seems so hard to remember those halcyon days, long ago, when there was some optimism about the country’s economic future. Why, it seems like just last week, when Fed Chairman Ben Bernanke was telling us to be cautiously optimistic about the near future.

In his twice-yearly testimony to Congress, Bernanke conceded the economy was undergoing a “severe contraction”, but held out hope of recovery if the White House’s latest bail-out helped to unblock lending to households and businesses.

“Only if that is the case, in my view there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery,” he told the Senate banking committee, adding that healthier global markets would also be essential if the US economy was to return to health.

Some were willing to go even farther, in those happier days of February, 2009.  Some chap named Bernard Baumohl of the Economic Outlook Group who seems really to believe that happier days are just around the corner.

“We are not doomed to a lost decade of the sort experienced by Japan in the 1990s,” Mr. Baumohl says. “Nor are we in a depression. We view the drop in GDP in the last quarter, which we may see repeated in magnitude this quarter, [as] symptomatic of a recession in its final convulsive stages, to be followed by a recovery in the second half of the year.”

Oh, wait.  That was last week.

This week started off with the S&P 500 dropping another 4.66% today, closing at 700.82, and the Dow off by 4.24% to close at 6,763.29.  Well, you can’t slip something like that past the boys at the Dallas Morning News.

“The number 7,000 is not what is important,” said Hugh Johnson, chairman of Illington Advisors in Albany, N.Y. “What is important to everyone is the message that the market is sending us with these losses.”

And that message is that the current recession probably will be longer and more severe than most people expected. For months, the consensus on Wall Street was that the low of 7,500 that the Dow hit in November 2008 would mark the bear market bottom.

Many market analysts predicted that while the Dow would “retest” that low, it would not break through it. They were wrong. The scary thing now is where the Dow and the broader Standard & Poor’s 500 index will make their next stand.

As I’ve mentioned several times, both on the blog, and on the podcast, the historical long-term trend is for the average P/E ratio to drop back to 15.  Well, that implies that our equilibrium point is somewhere in the vicinity now of 6,000 on the Dow, and about 620 or so for the S&P.  So we’ve still got a ways to go if that historical trend holds true.

Of course, we also have a tendency to drop below an average P/E of 15 as we pull back off the highs, so a 5,000 Dow doesn ‘t seem like an overly pessimistic prediction.

I know I’ve been consistently downbeat on the economy for the last several months, and nothing I’ve seen since I started writing about this in 2007 has changed my mind.  I’m not counting on a recovery in 2009, or even in 2010.