Credit Downgrade: What to Expect This Week

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"People do not get what they want or what they expect from the markets; they get what they deserve. ... Mr. Market doesn't give a hoot. He's got a 'Capitalism at Work' T-shirt on and a sledgehammer in his hand."
--
Bill Bonner

Now that America's credit rating has been downgraded, how is Mr. Market going to respond when the markets open Monday morning?

No one knows. It could be nothing, or it could be ugly. Maybe this is a wake-up call; maybe the damage is already priced in. The Wall Street Journal recently asked dozens of investors, bankers, and economists what the downgrade means. Nearly all gave some variation of I don't know. S&P appears to have accomplished what perpetual underperformance never could: It humbled Wall Street.

Although the future is unpredictable, the past is starting to make more sense. From my perspective, it seems that Thursday's 512-point selloff could have been triggered by early knowledge of the downgrade. There's no way to prove this, but think about it: There was no big news on Thursday. No banks failed. No hedge funds collapsed. No countries defaulted. If anything, Thursday brought a spate of earnings reports that should push corporate profits to an all-time high this quarter. Further, rumors of an impending downgrade were spreading like wildfire on Twitter by early Friday morning, more than eight hours before the news was made public. This all potentially bodes well for the markets going forward. Last week's bloodbath may have priced in the bad news.

Then again, it can't be stressed enough that the traders and algorithms controlling daily market movements have little in common with the long-term, business-oriented view of most Motley Fool investors. After the Flash Crash last May, New Yorker columnist James Surowiecki made a great point: "I don't think yesterday's crash is evidence the market is irrational. It's more that it's a-rational: The computers aren't panicking or herding. They're just following simple rules."

Those rules have nothing to do with the intrinsic value of businesses. They're more about a game of preempting one another -- computers trying to buy and sell before other computers buy and sell. If it comes, a selloff this week isn't necessarily indicative of panic and gloom. It could simply be the actions of short-term investors who are trying to get out first as they perceive that others will be panicky and gloomy. This is why it's so important to ignore short-term market moves and focus on business values.

The real threat from the downgrade is a potential rise in interest rates, which could slow the economy and swell budget deficits. But as I wrote last week, this is no sure thing. Japan's interest rates fell after it lost its AAA credit rating. JPMorgan Chase once did a study showing the effect on interest rates after a group of countries were stripped of their AAA rating. One week out, rates had hardly budged. On average, countries with AA credit pay more to borrow than those with AAA ratings do, but the difference is typically already reflected before a downgrade hits. This tendency bodes well for Treasuries, and it hits on a point that economists have been making lately: The Treasury market is so big, and there are so few alternatives, that the downgrade might just mean that AA becomes the new AAA.

And keep in mind that the downgrade should have surprised no one. S&P put the Treasury on negative-credit watch back in April, stating that there was a 50-50 chance the United States would lose its AAA rating in the near future. S&P's rationale for Friday's downgrade wasn't based on proprietary financial analysis but rather on a statement of the painfully obvious: America's political system is dysfunctional. Who didn't already know this?

Something else to be mindful of is who this downgrade came from: a rating agency with a dubious track record at best. If Goldman Sachs had downgraded Treasuries, no one would care. If Warren Buffett downgraded Treasuries, few would notice. Bill Gross, one of the world's most successful bond investors, ditched Treasuries earlier this year, and no one blinked. Asked about the consequences of the downgrade on Saturday, Buffett quipped: "Remember, this is the same group that downgraded Berkshire."

Indeed, the original downgrade report presented to the Treasury on Friday morning had a $2 trillion mathematical error. S&P doesn't dispute the mistake. After the Treasury pointed out the error, "S&P still chose to proceed ... by simply changing their principal rationale for their credit rating decision from an economic one to a political one," the Treasury wrote yesterday.

It's hard to argue that the United States doesn't deserve a downgrade -- particularly based on a dysfunctional legislature -- but keep it in appropriate context before making any personal investment decisions.

What do you think the downgrade means for your investments? Let us know in the comments section below.

At the time this article was published Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Follow him on Twitter, where he goes by @TMFHousel. The Motley Fool owns shares of JPMorgan Chase and Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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