Insights
US Debt Downgrade, A Letter from the President
As you know, I do not like to fuel a media-driven financial fire by even acknowledging their crisis du jour. But Friday’s downgrade of U.S. debt by Standard & Poor’s (S&P) is having quite a negative effect on investor psyches. Understanding can help combat emotional uncertainty, so I’d like to share my thoughts with you about the downgrade and the current state of our economy.
On Friday, August 5, after market close, S&P, lowered its rating on U.S. Treasury debt for the first time ever from AAA (the highest) to AA+. Moody's Investors Service and Fitch Ratings, two of the other three largest rating agencies, continue to rate America AAA. In 1917 Moody's assigned AAA as its initial rating to US debt. We had not lost it since.
Consider the following:
- This does not mean that America is considered unable to pay its debt. In fact, the price of U.S. Treasury debt has increased dramatically since S&P threatened the downgrade last month. As I write this message, all types of U.S. debt are trading close to record highs. The markets apparently feel we remain a relatively safe bet, and that is what really matters.
- But, while the bond market is reflecting little change so far, the stock market is falling. Frankly I attribute this to simple investor fear about the uncertainty. While the downgrade changes nothing fundamentally, it's one more piece of bad news after weeks of political bickering, which becomes wearing over time. All this talk has angered and frustrated investors, rendering them more sensitive to any additional negative economic news.
- In my opinion the downgrade is good news, in that it might serve as the catalyst for meaningful change. The U.S. does have a debt problem, and no current plan for addressing it. Unless pressure is put on our leaders to devise a plan, they will do what they usually do: nothing. And then the problem could (probably would) worsen. The downgrade will sustain the pressure, maybe enough to spur our leaders to do take appropriate action. If they do, then we and our children will be better off in the long run.
On the economy, it’s true we are not recovering as quickly as we’d like from the 2008–2009 recession. Our housing market remains unstable, and Europe is encountering real economic challenges, especially Greece. But we are recovering, if in a slow, herky- jerky manner.
Consider the following:
- In my opinion, the real problem with the stock market isn’t fundamental but physiological. When the psychology changes, the markets will reverse. And they’ll likely do so very rapidly, if history is our guide regarding run-ups following a correction. The only way to capture a run-up is to be there when it begins. Because we can’t know when that will occur, the goal is to ride out the challenges and be there always. Over time, the markets have never failed to historically reward long-term investors for their discipline.
- Greece has been insolvent in 125 of its last 200 years. Occasionally, the markets decide to focus on this. But mostly Greek debt issues are ignored. Today we are in a period when the markets care. Most likely, Greece will be bailed out by its stronger Euro neighbors and, after the pain is absorbed, it will cease to be a news item. Again, like our own debt challenge (which is nothing near the magnitude of Greece’s) the attention is helping to get the problem fixed.
- The stock market is valued at a very low level right now; at two-thirds of its historical average. Stocks are very valuable by most fundamental measures, and the further they fall the more the value increases.
- U.S. companies have increased earnings from $45 per year for the S&P 500 in 2008 to an estimated $98 in 2011 and $118 in 2012.
- Non-financial U.S. companies have increased their cash holdings from $654.6 billion in 2008 to $1.1 trillion in the first quarter of this year.
- Germany, Japan, China, Brazil, New Zealand, Australia and Southeast Asia are doing so well that their problem is how to manage the acceleration of the growth. We here in the U.S. tend to focus primarily on our own economy, with some consideration for what is happening in Europe. If we stand back and view the entire global economy, the situation is not bad.
So what is my advice to you? Unless your personal financial situation has changed, do nothing different. Do not let short-term market movement dictate your actions. Changes should only be made to portfolio design based on changes in your personal situation.
Consider the following. The average stock mutual fund returned 9.9% per year over the last 20 years (1991–2010). The average investor in stock funds earned 3.8%. So the investment return was 9.9% and the investor return was 3.8%. Why does this happen? Poor investor decisions resulting in ill-timed, costly trades based on greed when the markets are soaring and fearful panic when the markets plunge. This penalty of 6.1% is self-inflicted, and it’s why I ask you not to panic out of the markets when they fall, and all the news is doom and gloom.
Source: Quantitative Analysis of Investor Behavior by Dalbar, Inc. (March 2011) and Lipper
Here are some quotes from today’s, August 8 InvestmentNews article entitled ”Stock Futures Plunge, Global Shares Tumble,” which say it well:
“Investors should not panic,” Charles Reinhard, the New York-based deputy chief investment officer at Morgan Stanley Smith Barney LLC, which oversees $1.7 trillion, said in a telephone interview. “The downgrade is a disappointment, but it will be manageable. Underlying all of this we still have attractive equity valuations and good old fashioned profit growth.”
Billionaire Warren Buffett said S&P erred when it lowered the U.S. credit rating and reiterated his view that the economy will avoid its second recession in three years. The U.S. merits a “quadruple A” rating, Buffett, 80, said Aug. 6 in an interview with Betty Liu on Bloomberg Television.
One last thought:
Gold has run up to a record price of $1,700 per ounce. Should we be selling all and buying gold? The answer is ‘no’ and again let me explain why with some helpful quotes.
BUFFETT ON GOLD
“You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”
TWEEDY, BROWNE ON LUST FOR GOLD
“From its previous peak in 1980 of $667 per ounce to its current price of roughly $1,500 per ounce, gold has compounded at approximately 2.7% per year versus 3.2% for the Consumer Price Index. On the other hand, common stocks, as measured by the performance of the S&P 500, compounded at an annual rate of approximately 11%, including dividends, over this 30-year period.” — from the 2010 annual report of Tweedy, Browne Company
In today’s markets and in tomorrow’s, I truly believe that your most golden opportunities lie within continued adherence to your sensible, forward-looking portfolio, constructed toward achieving your own long-term goals. I will be reaching out to you to address any specific questions you may have. In the meantime, please be in touch immediately if I can be of assistance even sooner.
