Black Swans, White Noise.

August 8, 2011

On Friday afternoon, S&P downgraded the United States' debt rating from AAA (the best) to AA+. This symbolic gesture caps a frenetic period of political jockeying during which both parties attempted to score an ideological victory while the public breathlessly awaited an outcome.
S&P warned Congress that, short of a $4 trillion reduction in the deficit, a downgrade would be forthcoming. In lieu of the warning, Congress still fell short, cutting $900 billion, with an agreement to attempt another $1.5 trillion reduction by year end.
The downgrade appears more aligned with the political stalemate in D.C. than it is with the nation's ability to pay its bills. Most agree that the U.S. is in no danger of not being able to pay the interest on its debt. Still, S&P concluded its downgrade.
Since then, the cacophony of caterwauling against S&P has reached symphonic levels. Treasury and Fed officials. Money managers. Journalists. Even Warren Buffett--each stating that the downgrade "doesn't make sense."
Moody's and Fitch's, S&P's sister agencies, have reaffirmed their AAA ratings on U.S. debt. So for once, S&P appears to be leading the market, as opposed to following it.
Given the justifiable platitudes from both sides here (the U.S. should likely have been downgraded long ago, but S&P falls far short of having the moral credibility to justify such a call), it will be difficult in the near term to get a clear look through the windshield at the road ahead.
The white noise is deafening. So let's skirt the media frenzy and establish some facts.
While it could worsen, the economy has not been deteriorating as the media would have you believe. Job growth slowed in the post-Japanese earthquake soft-patch. But, it has recently begun to pick up. The private sector added 154,000 jobs in July, after creating just 80,000 jobs in June and 99,000 jobs in May.
New unemployment insurance claims fell to 400,000 last week after peaking at 478,000 back in April.
Average hourly cash earnings rose 0.4% in July, up 2.3% versus a year ago. When you combine this with a 2% increase in hours worked over the past year, worker incomes are out-trending inflation.
Auto production, severely impaired after the Japanese disaster, continues to exhibit solid third-quarter growth. July sales increased 6% from the June bottom and the replenishment of dealer inventories should further enhance sales.
Even housing, long denigrated in these weekly reviews, could be coming off the mats. Pending home sales rose about 11% these past two months--possibly portending a long-awaited inflection point that market.
Corporate America has certainly played its part. Second-quarter earnings for the S&P 500 are up over 17 percent year-over-year, predicated on a 13 percent rise in revenue.
Current conditions are similar to this time last year when the S&P 500 was down 15 percent and the Fed initiated the QE2 program. So, the possibility of QE3 has entered the room like a shadow. Clearly there, but not the centerpiece of conversation. And while that may or may not be a positive depending on one's point of view, QEs 1 and 2 have clearly been stock-market positive.
The Fed remains accomodative--Interest rates remain at all-time lows. Inflation remains in check.
M&A activity is accelerating, as are corporate stock buy backs. Companies are cash rich and seeking to to enhance their bottom lines.
Being optimistic during events like these can be challenging. Yet, one must align oneself with the facts. While we gaze nervously at many of the sovereign debt issues transpiring around the world, we ask ourselves: will these events translate into today's Black Swans that steer global markets into a chaotic downturn like we experienced in Q4 2008? At this point, we don't think so.
The European sovereign debt issues are worrisome, yet those governments are buying and supporting and their debt. But, the bond vigilantes continue to bounce from nation to nation in their search of warm carrion. And when these nations come under attack, the values of credit swap defaults rise, panic swells, and the volatile cycle continues.
Yet, today's world is no different than the once we faced last Thursday, except for the fact that S&P came out with a judgment call that runs counter to the opinions of their two largest competitors. But, it was enough to get the media machinery ramped up into overdrive, and so create an event where there was none before.
Unfortunately, this is sometimes how the messiness begins. And so we will be watching closely.
Finally, why do we face this situation at all?
There is an epic battle raging between political and economic philosophies. So opposed are the two sides that S&P gave Congress the answers before the test and still it could not cut $4 trillion. That seems a pretty apt summation of everything occuring in our nation's capital today. Two political foes, both with their hands on the wheel, just as willing to drive over a cliff as they are to concede an inch of ground.
And while we agree with S&P regarding the irresponsible direction of U.S. spending, we question the downgrade, its timing, and the moral rectitude in being able to justify such a call.
Yet, if this is what it takes to force D.C. to get serious about spending cuts, balanced budgets, and all other matters of fiscal propriety, then maybe this will bring positive consequences.
Meanwhile, the problem remains: does this market fall much further or will tomorrow bring a bounce?
We have raised cash. Sold high yield and floating rate bonds. And averaged into some of the best positions around that some weeks ago were pricier than we preferred. As always, amid the chaos, there will be opportunities.
ISI Group's John Mendelson categorized last week's selloff as follows: "There is nothing more bullish than fear nor more bearish than certainty."
In other words, if everyone is convinced the market will head higher, it may be a good time to sell. If everyone is fearfully jumping ship, it could be time to buy.
Do not panic. Until the Black Swans emerge, this remains a headline-driven market situation amid all of the typical white noise. One that is just as likely to turn on a dime tomorrow. Or maybe next week. Keep your hands on the wheel and stay tuned...

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