Felix Salmon

Chart of the day, global equity market edition

Felix Salmon
Aug 11, 2011 10:42 UTC


I love this global equity snapshot from Bloomberg’s Michael McDonough. For one thing, it clearly shows how European bourses are in much worse shape than those in the U.S. First look at the green dots in the little 52-week sparklines: the American and European highs weren’t all that far away from each other, chronologically speaking. And then look at the red dots: every exchange in Europe is hitting new 52-week lows, usually quite dramatically. By contrast, the U.S. indices all have their red dots over to the left: we still haven’t even dropped back to where we were a year ago.

A similar tale is told in the percentage-change columns. News headlines, of course, concentrate on what’s happened on a daily basis, with U.S. stocks down more than 4% and European stocks trading up on the day. But take a step back and the bigger picture is rather different: the sea of red, marking stock markets down more than 20% from their 52-week highs, is almost entirely European. And the biggest loser of all, the Italian market, is down a whopping 35%. If the Dow fell that much from its 52-week high, it’d be at 8,331, with the S&P at 887.

The lessons here, then, are firstly that if you spend your time looking at intraday stock-market movements on a country-by-country basis, it’s easy to miss what’s really going on. I’m in the UK right now, where there are lots of headlines about the plunging stock market, but no indication that it’s up there with Canada as the best-performing stock market in the world.

And secondly, the Eurozone is in serious trouble. Instead of looking at the amount that the markets have fallen from their highs, try looking at the degree to which they’ve recovered from their lows. The Euro Stoxx 50 hit a low of 1,809 on March 9, 2009; it’s rallied 18% since then. By contrast, the S&P 500 is up 101% from its March 2009 low: even after Wednesday afternoon’s swoon, it’s still at more than twice the level it closed at on March 5 of that year.

Does this mean that U.S. stocks simply have that much further to fall, before they catch up with their European counterparts? I suppose that’s one way of looking at it. But more realistically, the worst-case scenario for the U.S. is a double-dip recession; the worst-case scenario for the Eurozone, by contrast, is downright existential. Even on an up day today, the French banks are still seeing their shares marked down ever further. The very solvency of the Eurozone banking system in general, and the French banking system in particular, seems to be in doubt. U.S. banks don’t have that kind of European sovereign exposure, so we have a significant advantage on that front.

It might seem a bit like schadenfreude to take solace in the fact that other countries are much worse off than we are. But as the current stock-market volatility continues, it’s worth keeping such things in perspective. Europe is a global economic powerhouse; it can’t suffer these kind of woes without infecting the rest of the world somehow. And the U.S., in the grand scheme of things, seems — still — remarkably insulated from what’s going on across the Atlantic.


Wow, 666? A 5% dividend from KO, 6% from PG or JNJ?

I’m salivating… I thought we were in a market environment that promised *LOW* returns, not record-breaking dividend yields!

This isn’t 2001, or even 2008. Most of the big companies have real profits, and most of those profits are generated outside the US.

Posted by TFF | Report as abusive

Lessons from stock-market volatility

Felix Salmon
Aug 10, 2011 08:55 UTC

Didja see? Stocks went down, and then they went back up again. If you just spent the entire period lying in blissful ignorance on a beach, then you would have saved yourself a lot of stress and panic. And there was very little in the way of actual news, either. The scandal isn’t that S&P might have told banks and hedge funds it was going to downgrade the US: the scandal is that S&P told everybody, repeatedly, that it was going to downgrade the US, and the markets ignored the news until it actually happened. Similarly, there’s precious little actual news in the FOMC statement — certainly not enough to move the market by 5%.

So as ever, the best thing to do, if you’re saving for the long term, is to just keep on putting a small amount of money into the stock market every time you get your paycheck — and to ignore short-term stock-market gyrations. The stock market, at some point in the future, will be lower than it is now. And at some other point in the future it will be higher than it is now. We mere mortals can’t hope to time such things.

All we can really hope to do is put our money somewhere where it’s more likely to earn a decent real return over the long term than it is to get eroded away. And there’s simply no way that bonds or cash are superior to stocks on that basis, given their current yields of zero.

Obviously, the stock market is a dangerous place for short-term speculation — and if you can’t afford to see a 5% drop in one day, or a 20% drop over the course of a few weeks, then you shouldn’t be investing in stocks at all. It’s not a place for money you’re likely to need to spend any time soon. But if you’re a long-term investor, the one advantage you have over the big institutions is that you don’t mark to market, and are therefore less likely to be forced to puke up liquid and valuable stocks when markets fall. Take advantage of that, stay calm when markets get volatile, and over the long term you’ll be glad.


hsvkitty, it really depends on whether you expect “slow growth” or “no growth”. If you expect “slow growth” in the global economy (not necessarily the US and Europe), then there are already bargains on the table. If you expect the global economy to shrink, or to completely stagnate, then we should expect prices to fall further.

I started buying again yesterday, and will continue to buy as money comes in as long as the market stays in its present range.

Buffett also claims to be buying.

Posted by TFF | Report as abusive

The difference between S&P and Moody’s

Felix Salmon
Aug 9, 2011 19:30 UTC

Amidst all the downgrade talk, one crucial point has been largely missing: there’s a very good reason why it was S&P, and not Moody’s, which downgraded the US. It’s this: the two companies don’t measure the same thing with their credit ratings.

An S&P ratings seeks to measure only the probability of default. Nothing else matters — not the time that the issuer is likely to remain in default, not the expected way in which the default will be resolved. Most importantly, S&P simply doesn’t care what the recovery value is — the amount of money that investors end up with after the issuer has defaulted.

Moody’s, by contrast, is interested not in default probability per se, but rather expected losses. Default probability is part of the total expected loss — but then you have to also take into account what’s likely to happen if and when a default occurs.

The difference, as it applies to the US sovereign credit rating, is enormous. No one doubts America’s ability to pay its debts, and if the US should ever find itself in a position where it’s forced by law to default on a bond payment, that default is certain to be only temporary. Bondholders would get all of their money, in full, within a couple of weeks, and probably within a few days.

Contrast that with, say, some incomprehensibly complex constant proportion debt obligation, which makes all of its payments by dint of clever leverage games, and which, if it ever does default, does so with utter finality, and will never pay out a single cent again.

Let’s say, then, that Tim bought Treasuries in 2006, with their triple-A rating, while Chris bought triple-A CPDOs. They both had the same rating, but Treasuries were safer, and therefore had a lower yield. Tim was paying a premium for the liquidity associated with Treasuries: he knew that there would always be a willing buyer for them, even in the event of a default. And it’s conceivable that there was a tiny premium too for the fact that the recovery value on Treasury bonds is likely to be very close to 100%: if there ever is a default, investors will ultimately get back everything they’re owed. Chris, by contrast, knew that in the event that his CPDO defaulted, he’d get no money back at all.

All of those are very good reasons for Tim to pay more for his bonds than Chris paid for his. But all of them are explicitly ignored by S&P. S&P doesn’t put itself forward as some kind of investment-advice company: it takes no position on which bonds are good buys and which ones should be sold. All it does is try to rate credits on the basis of how likely they are to default.

Moody’s, by contrast, appreciates that bonds are investment instruments, and tries to build into its ratings the likelihood that investors will end up getting all their money back at the end of the day, rather than simply measuring how likely it is that there might be a default.

Here’s David Levey, for instance, the former managing director of sovereign ratings at Moody’s:

US Treasury bills and bonds, along with government-guaranteed bonds and highly-rated corporates, will for the foreseeable future remain the assets of choice for global investors seeking a “safe haven”, due to the unparalleled institutional strength, depth and liquidity of the market. Although there are several advanced Aaa-rated OECD countries with lower debt ratios and better fiscal outlooks than the US, their markets are generally too small to play that role. Since ratings are intended to function as a market signal, it makes little sense to implicitly suggest to investors seeking “risk-free” reserve assets that they reallocate their portfolios toward these relatively illiquid markets.

This is a very Moody’s thing to say, and is quite different from how the people at S&P think. S&P bends over backwards to try to say that it is not sending a market signal, and that a downgrade is not the same as a “sell” rating. Moody’s, by contrast, is a bit more realistic and appreciates that people use its ratings in the context of deciding which bonds to buy and which bonds to sell.

If Moody’s were to downgrade the US, then, that would indeed be an implicit suggestion that investors rotate out of Treasury bonds and into safer credits like, um, France and the UK. Which is a pretty silly idea. But S&P isn’t Moody’s, and so I think that Levey is wrong to say that S&P is making that suggestion.

Similarly, Nate Silver has a long post on “why S&P’s ratings are substandard and porous” which starts with the point of view of “an investor looking for guidance on which country’s debt was the safest to invest in.” That’s something you (purportedly) get from Moody’s; it’s not what you’re getting from S&P.

Silver also has a big problem with the fact that S&P ratings are more correlated with the Corruption Perceptions Index than they are with things like GDP growth or inflation, or debt. That fact, he says, “suggests that S&P is making a lot of judgment calls about countries.” Which, well, yes. Sovereign defaults are always political, rather than economic: if you looked only at macroeconomic ratios, then Ecuador should be investment grade, as would just about any other country which has recently defaulted and wiped out most of its debt. A sovereign credit rating is therefore primarily a function of a country’s willingness to pay, rather than its ability to pay.

Silver goes on to complain that credit ratings are a lagging indicator: upgrades and downgrades tend to lag the market, rather than anticipate it. Again, this is a complaint only if you think of the ratings agencies as being some kind of guide to help people beat the market. But they’re not. Sovereign upgrades and downgrades are big, important things, and the ratings agencies take their time over them — they’d much rather err on the side of caution and act too late than jump onto some wave of excitement and then regret doing so a few weeks later. That kind of activity they’re happy to leave to markets.

This is also the reason why S&P doesn’t much go in for multi-notch downgrades. Silver is right when he says this means that a country which has been downgraded to AA is a worse bet than a country that has been upgraded to AA: the former is much more likely to get another downgrade than it is an upgrade, while the latter is on an upgrade path and is more likely to get another upgrade than a downgrade. So they’re not exactly the same.

But the ratings agencies are very good at emphasizing that two countries with the same credit rating are far from identical in other respects. Again, S&P — and even Moody’s — would never say that investors should be agnostic when it comes to choosing between countries with the same credit rating. They’re just being cautious when it comes to their ratings moves, going slowly rather than quickly because that way they won’t make major multi-notch mistakes and they’re giving countries the opportunity to stop the deterioration in their ratings. The markets love to give an immediate verdict on creditworthiness: if you want that kind of thing, just look at bond prices or CDS spreads. Credit ratings are something different, which is a good thing.

Silver’s main thesis seems to be that the markets are a better guide to the markets than the credit rating agencies are. Which is true as far as it goes, but misses what it is that the ratings agencies in general, and S&P in particular, actually do. They’re a datapoint, not a financial advisor: ratings are more of a constant, in contrast to bond prices, which are highly variable. If you want a guide to bond prices, look at bond prices. If you want a guide to default probabilities, however, then the ratings agencies are still a good place to start.


Why do you think if the US defaults that the holder of 30 year treasuries are going to 100% of their principal back? On what basis are you making this claim? You think the holders of this debt have call over what assets is exactly?

Chris on the other hand has call on the assets whose cashflow is his debt is securitised against.

Also how liquid do you think the 30 year off the run treasuries are? Remember S&P downgraded US long term debt not t-bills.

Posted by Danny_Black | Report as abusive

Buy stocks, sell bonds

Felix Salmon
Aug 8, 2011 19:21 UTC

S&P downgraded the U.S. on Friday evening; the markets then had all weekend to work out what that meant, with the verdict arriving when markets opened Monday morning: stocks fell about 1.5% or so. That was about right, it seemed to me: the downgrade was important enough to take seriously, but not important enough to panic about.

And then stocks just kept on falling. As I write this, the S&P 500 is down 5.6% on Monday, wiping out a year’s worth of gains. That’s a big move, and no one knows where it might end.

From a market-dynamics perspective, we’re now in the world of momentum trades and falling knives. This isn’t a repricing of risk based on new information: it’s a trader’s market, which will move in the direction of inflicting the maximum amount of pain on the maximum number of people.

I’m not saying that this is an overreaction — the U.S. downgrade is a legitimately momentous event, and will have a large number of unknowable repercussions. A world which highly values predictability and certainty has become significantly less predictable and certain than it was last week. Does that mean that U.S. stocks are worth 20% less than they were at the market highs around 1,370 on the S&P? No — and that’s one reason I’m looking at this move more like a 20%-off-sale than a sign of incipient economic Armageddon.

What’s fascinating is the way in which all of the carnage is happening in the stock market, rather than the bond market: Treasuries themselves — the very instruments which were just downgraded — are up on the day, with the 10-year bond yielding a shockingly low 2.36%.

Faced with all this, what’s an individual investor to do? The first best answer in all such situations is always the same: nothing. Times of high volatility and market panic are a great time to go off to the beach and try to forget about your retirement portfolio — you want a clear head and a long-term horizon, rather than an obsession about what markets did today.

That said, however, one strategy might make sense, given what’s happened to stock and bond markets of late: a simple portfolio rebalancing. What’s your ratio of stocks to bonds? If you had it where you wanted it a few months ago, then right now, with stocks down and bonds up since then, you’re likely overweight bonds. So sell some bonds (they’re very expensive, thanks to all this panic), and buy stocks with the proceeds, until you’re back to your optimal asset allocation.

And while you’re at it, you might want to revisit that asset allocation, and ask yourself whether having all that money in bonds is particularly smart. If you’re invested for the long term — a 10-year time horizon, say — then a 2.4% yield over those 10 years is utterly pathetic, and can easily get eaten away by inflation alone. Meanwhile, with expected earnings of $99.83 per share this year, the earnings yield on the S&P 500 is a whopping 8.8%.

This is one of those times that stocks genuinely look safer than bonds. They might well go down, of course, in the short term. But on a relative-value basis, they’re looking decidedly cheap.


Really a very good information that will be so helpful.


Posted by GilBurt | Report as abusive

The downgrade FAQ

Felix Salmon
Aug 8, 2011 11:26 UTC

I’ve received some fantastic responses to my post about the S&P downgrade, so let me answer a few of the questions raised. Call it a downgrade FAQ:

S&P is making a political statement in keeping with the current climate of deficit hysteria, and I don’t know why anyone continues to give them the time of day.

Besides, Congress is the most dysfunctional it’s ever been, and they managed to get the ceiling raise passed. Is there really reason to believe it will get WORSE? I mean really, the debt ceiling debate bordered on the absurd. Why are you so fatalistic about future Congresses? Surely, surely they can do better.

These are both good points from loudnotes. There’s a lot of fuel for the deficit-hysteria fire in the S&P statement, much of which can reasonably be filed under “unnecessary at best and incendiary at worst”. For instance:

Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.

There are three messages here which I would take serious issue with. The first is that the higher the immediate discretionary-spending savings, the better — we need less spending now, rather than more. In fact, short-term changes in discretionary spending are, to a first approximation, utterly irrelevant to the long-term fiscal position of the United States. The second is that entitlements in general — something which includes Social Security — need to be reined in for the purpose of “long-term fiscal sustainability”. In reality, Social Security is fine: it’s medical cost inflation that is the real problem. And you don’t necessarily fix that by making Americans entitled to less in the way of medical services if they’re poor or old.

Most importantly, there’s a hidden syllogism here: that if we don’t get onto a path of long-term fiscal sustainability, we’re more likely to end up defaulting in the future. I’d really like to see this spelled out, in a world where the U.S. borrows only in its own currency. There are certainly problems associated with big debts and big deficits, but it would be helpful if S&P spelled out how those problems mean an increased likelihood of default. There is real value to the exorbitant privilege of being able to borrow in dollars when the dollar is not only your own currency but also the global reserve currency — and a large part of that value, it seems to me, is never having to default unless you want to. The U.S., as the home of the dollar, really is special, but the S&P statement never addresses that fact, instead simply comparing U.S. debt ratios to ratios in other countries as though all triple-A countries are equal in this respect. They’re not.

That said, however, political realities alone are sufficient to rob the U.S. of its triple-A rating, and S&P had enough maturity to wait until after the debt-ceiling debate concluded before it went ahead and downgraded. There was definitely a point in the debate at which the triple-A was lost, and you can’t really blame S&P for that: you have to blame Congress in general and the Tea Party Republicans in particular. Can future Congresses do better? Yes. Will they? We don’t know. And if we don’t know, then America doesn’t deserve a triple-A rating.

We’ll always pay our debts back in full, if necessary just by printing the dollars to do so, but what does that matter if we need high inflation in order to do that? Devaluing our currency by printing money is just default by another name.

This is both true and untrue at the same time. Yes, inflation eats away at the value of Treasury bonds as surely as a default would. But that doesn’t mean it is a default. When a government issues debt, inflation expectations are baked in to the price the market will pay for those bonds; the ratings agencies emphatically do not consider inflation to be a default. If they did, then there’s no way that the U.S. could have had a triple-A credit rating through the 1970s and early 1980s. In order to default on your debt, you need to default in nominal dollars. That’s what the ratings agencies care about.

S&P should have made it clear that this problem was made by the Republicans.

I have a lot of sympathy for this, but I can also see how, on a practical level, it doesn’t help S&P to be considered a Democratic-party partisan. And S&P did actually single out the Republicans for implicit censure:

Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act.

S&P is saying here that it cares about fiscal sustainability; that increased revenues are a key part of any credible fiscal-sustainability pact; and that the Republicans seem to have a veto over increased revenues. It doesn’t take all that much reading-between-the-lines to see S&P singling out the Republicans for blame here.

S&P should have made it clear that this problem was entirely a function of the fact that we have a debt ceiling in the first place.

Yes. I think it’s fair to say that if there wasn’t a debt ceiling, the downgrade would not have happened.

S&P didn’t downgrade after Bush and a GOP-held Congress inflated the federal deficit to mammoth proportions eight years ago. Or right after the midterms. That would have been acceptable… it would have been like an ‘independent’ referendum on what happens when you let crazy people run your country.

Why now? After the debt limit has been raised (for nearly two years)? I suppose it’s still acceptable to downgrade now, but I think it shows where the ideology of S&P lies, don’t you?

I don’t buy this, from Sprizouse. S&P didn’t downgrade based on mammoth Bush deficits for the same reason that it didn’t downgrade based on mammoth Obama deficits — deficits alone are not sufficient for a downgrade. Similarly, the fact that we managed to get the debt ceiling passed is a short-term fix to a fundamental problem, which is the existence of the debt limit in the first place. If the debt limit were a theoretical thing, like it is in Denmark, then that would be OK. (The Danes are currently 38% of the way to hitting their debt ceiling.) But it’s not: the debt limit is only ever raised in small increments, necessitating another vote shortly down the line.

There are Republican notes in the S&P statement — the talk about entitlement reform, for instance — and there are Democratic notes too, like the bit about revenue increases. Basically, S&P is just being fiscally hawkish and that’s something which cuts across both parties. The most fiscally prudent administration in living memory was Clinton’s. Bush was gratuitously bad on the fiscal front: he didn’t need to enact those monster tax cuts. Obama was necessarily bad on the fiscal front: he inherited a recession and had no choice. But the flip-side of stimulus spending in a recession is tax rises when the economy starts to recover so that you can pay for all that stimulus. If Congress refuses to enact any such tax hikes, that’s a problem. And so it makes sense that the downgrade came now, when Congress’s intransigence came into full focus.

You defended S&P by saying that even though it helped cause the problem, at least it’s correct in pointing out that the problem exists. Couldn’t you defend the Tea Party on the same basis?

Very clever, John Quiggin.

Isn’t this a conspiracy between S&P, on the one hand, and the big Wall Street primary dealers, on the other? If they’re short Treasuries, S&P is doing them a massive favor.

No. Even if Wall Street was short Treasuries, no one on the Street would welcome a U.S. downgrade. Virtually everything that Wall Street does in the fixed-income area is built on the distinction between rates and credit. S&P has now muddied that distinction in an extremely unhelpful manner. Wall Street banks are much easier to run when Treasury bonds are a safe place to park cash and the further away from Treasuries you move, the riskier your position is. S&P is ushering in a much more multivalent world, which massively complicates just about every risk management system. And risk management is already hard-to-the-point-of-impossible, if you’re a major Wall Street institution. Besides, Wall Street was long Treasuries, not short.

What qualifies S&P to be uniquely suited to pass such judgments on sovereign debt?

Nothing. Lots of people, myself included, make these judgments on a regular basis. People listen to S&P more than they listen to me and part of that is due to the fact that S&P has official status as a Nationally Recognized Statistical Ratings Organization. In an ideal world people would not privilege S&P’s opinions — but in an ideal world, everybody would do their own due diligence on issuers’ creditworthiness before buying bonds. And that doesn’t happen. And in that ideal world the U.S. wouldn’t be getting artificially cheap borrowing rates due to the fact that Treasury bonds are the first-choice asset for everybody from foreign central banks to tri-party repo operations. We live in a world where certain entities have privileged status due to their position. And that cuts both ways.

Should we accept S&P as an authority on this matter?

No, for reasons which commenter http spells out. Krugman’s right about this, at least: given how disastrously S&P behaved during the subprime bubble, we shouldn’t consider them particularly reliable in this instance. But one good thing that has become clear in the past couple of days, since the downgrade, is that no one is accepting S&P’s judgment unquestioningly.

Finally, there are three very good questions from Jay Rosen, which encapsulate a lot of the questions here.

1. Compartmentalization: You have some theory of compartmentalization here that needs to be spelled out. From my reading, S&P’s performance on mortgage debt revealed a company with institutional integrity and domain competence very close to zero. I understand (meaning: I read Tyler Cowen’s post and your endorsement of it) that I am supposed to be dismissed as unsophisticated, a cover-up artist, or an agent of distraction for mentioning any of that in this context, but here’s what I don’t get… How is it that S & P was capable of a pathetic default in responsibility on mortgage debt, but the same company is now shrewd, reasoned, prudential, tough-minded and basically right about government debt? You must have some theory of corporate culture, or compartmentalization, that you are not articulating. I want to know what it is.

My point here is that there are two issues. The first is whether the U.S. deserves to be rated AAA; the second is whether S&P is competent. We can argue the latter as much as we like, but let’s not let the latter argument interfere with the former. I’m saying that if S&P were shrewd, reasoned, prudential, tough-minded and basically right, then it would have downgraded the U.S. I’m taking no position on whether S&P is shrewd, reasoned, prudential and tough-minded and basically right. Hell, I even take issue with their reasoning! It’s only their conclusion I’m agreeing with.

That said, I do think that there is real compartmentalization going on at S&P, in particular between the structured-credit group and the sovereign group. The two groups have very little in common and mistakes at the former don’t commute automatically over to the latter. I’m willing to believe that the sovereign group has some kind of integrity even if the structured-credit group didn’t.

2. Lesson learning: You seem to be suggesting that an utterly incompetent, asleep at the switch, failed-in-the-clutch company has somehow learned its lessons and is now trying to get ahead of the next crisis. So I am curious: did you find evidence of this stock-taking and lesson-learning, some sober, coming-to-grips with massive institutional failure, in the testimony of the ratings agencies heads before Congress and the FCIC? I did not see any evidence of that. But maybe you did. Please advise.

No, I didn’t. And I’m not saying that S&P has learned from its mistakes. I’m just saying that they’re not making the same mistakes again.

3. I take your point that this a political assessment, and not really a by-the-numbers call on the economics of the debt. I certainly agree with that. But you seem to be saying (correct if I am wrong) that Standard & Poors made a bold, candid, clear-eyed and realistic political call by downgrading the U.S. I’m sorry but I cannot believe you. For a bold, candid, clear-eyed and realistic political judgment would not mince words about what has changed; it would say flat out, “The Republican party has changed. It is now willing to de-stabilize the system and introduce radical doubt about the willingness of the U.S. to make good on its promises. This is new. This is unprecedented. And it is this development that has brought us to the point we are at now.” But nothing like that appears in the S&P opinion, which I have read. It goes all “both sides” on us. Why? If I believed your analysis, I would expect far tougher and more candid language than we actually see in the opinion.

I’m not convinced that the S&P statement does the “both sides” thing — the Republicans are criticized by name, while the Democrats are mentioned only in the context of not being able to agree with the Republicans.

Should S&P have come out with a partisan statement singling out for particular opprobrium the Republicans in general and the Tea Party in particular? I, for one, would have enjoyed that. But there are good reasons why S&P, as a Nationally Recognized Statistical Ratings Organization, can’t do that. Remember all that empirical mathematical veneer in the statement — it’s there to make the rating look Statistical. Political rhetoric has the opposite effect.

When markets open today, they will be weak, but they won’t crash. And that’s because the S&P rating is ultimately being received exactly as it should be received — as a considered opinion from one organization, rather than as some kind of revealed Voice of God judgment of U.S. creditworthiness. If the downgrade has further weakened public opinion of the ratings agencies, that’s a good thing: we want the ratings agencies to have less power. But that doesn’t mean that S&P was wrong in this instance.


klhoughton, you might be waiting a while for that trade to pay off given S&P cut long term ratings only.

Mr Salmon, you are off course assuming that the liabilities are not inflation linked. The UK for instance has a ton of off-balance sheet debts that would make Enron blush but apparently not Gordon Brown. They are for the most part inflation linked. The unfunded public sector pensions are also inflation linked. No idea about the US but would be suprised if there is not also a bit of this monkeying about.

Posted by Danny_Black | Report as abusive

The credibility and integrity of S&P’s ratings action

Felix Salmon
Aug 6, 2011 23:33 UTC

Treasury’s official response to the S&P downgrade has arrived, and it makes for pretty depressing reading. Treasury’s taking a shoot-the-messenger approach: S&P made a mistake in its debt-sustainability calculations, they say, and therefore “the credibility and integrity of S&P’s ratings action” must be called into question.

Paul Krugman takes a similar tack:

it’s hard to think of anyone less qualified to pass judgment on America than the rating agencies. The people who rated subprime-backed securities are now declaring that they are the judges of fiscal policy? Really? …

This is an outrage — not because America is A-OK, but because these people are in no position to pass judgment.

Tyler Cowen warned about this:

As a simple rule of thumb, if at this point, in response to this news, a commentator attacks the ratings agencies for their previous mistakes and stupid, corrupt behavior, it’s a sign the commentator is trying to muddy the broader issues.

Yes, the ratings agencies were in large part responsible for the financial crisis. But their mistake there was having too many triple-A ratings. If you were looking for a sign that they’d learned their lessons, it would be that they were downgrading triple-A borrowers before crisis hit. And also that they didn’t place overmuch stock in official models. Whatever else S&P is doing here, it isn’t repeating its mistakes of the subprime bubble.

Treasury says that “the foundation for S&P’s initial judgment” was its debt-sustainability calculations, and that S&P only pivoted to a more political willingness-to-pay argument when the initial econometric argument fell apart. But this doesn’t make sense: S&P has no particular incentive to downgrade the US, and every incentive not to.

Instead, to understand S&P’s actions, you just need to understand two basic facts. The first is that S&P is not judging the quality of Treasury bonds as an investment. There’s a key difference between S&P, on the one hand, and Moody’s, on the other: when rating sovereigns, S&P doesn’t care about or look at the likely recovery in the event of default. If the US ever did default, investors would ultimately get back 100 cents on the dollar, interest included. Shorting Treasury bonds into that kind of a default wouldn’t make you much money. But it would still be a default — and S&P is trying to gauge the likelihood of such a thing happening.

Secondly, and more importantly, all sovereign defaults are political, not economic — especially defaults by countries which borrow exclusively in their own currency. S&P and Moody’s can look at all the econometric ratios they like, but ultimately sovereign ratings are always going to be a judgment as to the amount of political capital that a government is willing and able to spend in the service of its bonded obligations. If Treasury really believes that S&P based its judgment fundamentally on debt ratios and the like, it’s making a basic category error about what it is that sovereign raters actually do.

This part of the S&P statement isn’t some kind of hurried fallback justification for the downgrade, it has to be central to any decision to downgrade the US:

The downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges…

The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge.

Any student of sovereign default knows that it is born of precisely the kind of failures of governance that we saw during the debt-ceiling debate. That is why the US cannot hold a triple-A rating from S&P: the chance of having a dysfunctional Congress in future is 100%, and a dysfunctional Congress, armed with a statutory debt ceiling, is an extremely dangerous thing, and very far from risk-free.

Yes, there’s a lot of fiscal math in the S&P statement. But at heart, any sovereign ratings decision is political, not economic: the economics is there to provide a veneer of empirical respectability to what is fundamentally a value judgment. We saw the values of Congress during the debt-ceiling debate, including various members of the House who said with genuine sincerity that they’d actually welcome a default. In that context, S&P’s judgment is hard to fault.


It never ceases to amaze me, how many people are so easily duped by BAD JOURNALISM, and then are controlled by the deceptions to keep spouting and repeating those inaccuracies. UNTIL very RECENTLY 97% of our government public Servants have been pulling the wool over our eyes, robbing the till, taking bribes, committing fraud, and shredding the Constitution slowly and quietly. All of a sudden the people began to wake up, and from ALL parties they began to form a grass roots movement to take back our government. It is called the Tea Party. Naturally, There is a great deal of backlash from all of the Socialist govt and media control freaks. Thus it SEEMs to observers like there is a majority of “thinking people” who agree that the Tea Party is made up of a bunch of psychopathic, racist, sexist, hate-mongering, homophobic, religious, morons; Therefore it MUST be true. So we get the ridiculous comments above blaming them. The Truth is our Public Servants have been overspending, and maxing out our credit, which have been driving us inevitably toward the cliff, and Now that there was a veiled threat – suggested conveniently by the Dems with the most to lose if the TP are seen as the heroes they are – The Tea Party folks are only insisting that we get our finances in order. If we are going to avoid default, or recover from default, we are going to have to do exactly everything that the TP has been demanding, and the sooner we do, the better. Every day that we delay to do these things will delay the recovery time exponentially. The Tea Party represents me, and millions of others who want the American Dream back, and it will only be acquired from the bullies, with a gun to our head, who have taken it by the tenacity of the bull dog who bites and refuses to let go until the bullies let go of the gun.

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Why the S&P downgrade was delayed

Felix Salmon
Aug 5, 2011 23:56 UTC

The S&P downgrade noise out of Washington right now is decidedly unclear; most of it seems to be confined to Twitter, with this being one of the few exceptions. But the general understanding is that S&P decided to downgrade the US, told the White House, got serious pushback, and ultimately — for the time being — did nothing.

There are three points worth making here, even in ignorance of the details of what went on behind the scenes today.

Firstly, talk of debt-to-GDP ratios and the like is a distraction. You can gussy up your downgrade rationale with as many numbers as you like, but at heart it’s a political decision, not an econometric one.

Secondly, the US does not deserve a triple-A rating, and the reason has nothing whatsoever to do with its debt ratios. America’s ability to pay is neither here nor there: the problem is its willingness to pay. And there’s a serious constituency of powerful people in Congress who are perfectly willing and even eager to drive the US into default. The Tea Party is fully cognizant that it has been given a bazooka, and it’s just itching to pull the trigger. There’s no good reason to believe that won’t happen at some point.

Finally, it’s impossible to view any S&P downgrade without at the same time considering the highly fraught and complex relationship between the US government and the ratings agencies. The ratings agencies are reliant on the US government in many ways, and would be ill-advised to needlessly annoy the powers that be. On the other hand, the government has been criticizing them harshly for failing to downgrade mortgage-backed securities even when they could see that there were serious credit concerns. So by that measure they have to downgrade the US: the default concerns we saw during the debt-ceiling debate were real and can’t be ignored.

I wouldn’t be at all surprised to learn that substantially all of today’s market action was attributable to the status of the S&P downgrade. Stocks opened higher on the strength of a decent jobs report, fell off when it looked as though the downgrade was coming, and then rallied back when it became clear that it wasn’t, ultimately ending the day flat.

If that’s the case, then we can probably expect an immediate sell-off of no more than a few hundred points on the Dow if and when the S&P downgrade finally arrives.

But that won’t be the end of the story, by any means. Alan Taylor and Christopher Meissner have a long new paper out looking at the value of America’s “exorbitant privilege” — they put it at roughly 1% of GDP and falling. That’s $150 billion a year or so. An S&P downgrade would surely accelerate the decline, by some unknown amount.

Do the mandarins at S&P — people who, it seems, can’t even get basic macro sums right — really want to cost the US economy tens of billions of dollars a year by downgrading the country’s debt and causing all manner of potential market mischief as a result? I can’t see that there’s much in it for them, even if a downgrade is the intellectually honest thing to do.

Eventually, we can be sure that the US will be downgraded. But this is a bit like the banks’ rearguard action on debit interchange: simply delaying the inevitable is worth billions to the government. So expect as many delaying tactics as Treasury can lay its hands on. You can be sure that everybody in the sovereign group at S&P is under enormous pressure right now. They’re going to take their time before taking this essentially irrevocable step.

Update: This was, obviously, posted about half an hour too early: S&P went ahead and downgraded the US after all. It’s not a surprising move, but it’s seismic all the same. The immediate consequences will be significant; the long-term consequences will be orders of magnitude larger. And I do think it’s fair to pin the lion’s share of the blame on the existence of the debt ceiling.


“The process now necessary is essentially unprecedented and every bureaucrat on the hill will be screaming bloody murder. Washington will NOT have a Merry Christmas.”

I waver between “wholehearted agreement” and “I’ll believe it when I see it”. Enjoy!

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Felix TV: Time to chill out

Felix Salmon
Aug 5, 2011 17:26 UTC

Jason Varone was not impressed by this video. “I guess you don’t know anyone trying to retire?” he tweeted in response.

Actually, I do. But retirement isn’t — or shouldn’t be, in any case — a day on which you suddenly liquidate your entire stock portfolio and go from risky stocks to safe cash. As we get older and more risk-averse, we should hold fewer risky stocks and more safer bonds. (Although the idea that bonds are particularly safe is something you might want to reconsider, these days.) Retirement is the point at which you stop putting money into your retirement account — and therefore the point at which you stop buying more stocks. But not-buying isn’t the same as selling.

What’s the optimal asset allocation for someone who’s retiring right now? The answer there depends on a huge number of variables — whether you own your own home, what kind of a mortgage you have, what your monthly expenditures are, what kind of Social Security income you have, etc etc etc. But one thing I can say: the amount of stocks you have the day before you retire shouldn’t be vastly different from the amount of stocks you have the day after you retire.

Yes, there’s always a small number of people who are genuinely hurt by a big stock-market sell-off — people who for some reason have to sell now and who would in hindsight have been much better off selling a few weeks ago. But I don’t see a lot of forced selling in the market right now, and I don’t think there are all that many people in that position: while unemployment is still at very high levels, the amount of new unemployment — people being laid off, and forced to live on their savings — is quite low, and the economy is gaining jobs, not losing them.

As for the rest of us — the employed majority — we should just continue to dutifully put aside a chunk of money every paycheck, and invest it in the broad stock market. Sometimes our retirement account will go up, and other times it will go down. But over the long term, simply putting money in every month is the most important thing of all — that and not panicking when the market gets volatile.


“You have a lot more faith in companies’ reported earnings than I do.”

Depends on the company, JayCM, but I suppose I do…

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How stocks react to the macroeconomy

Felix Salmon
Aug 5, 2011 12:22 UTC

Mohamed El-Erian has the best explanation of what happened in the markets yesterday. First and foremost, there were “technical factors”. This doesn’t mean lines on charts and head-and-shoulders patterns and similar astrological nonsense, but rather the dynamics of where investors’ money was being held and the amount that the market would fall given a modest downward nudge. Sometimes that number is tiny, but it can fluctuate a lot, and yesterday it just happened to be huge.

Then there are four long-term factors which conspired to give the markets their current bearish outlook.

First of all are concerns about a double-dip recession and broad weakness in the US economy; Floyd Norris has a good column on this today.

Secondly there’s the end of QE2, with no indication that QE3 might appear any time soon. In English, the Fed isn’t pumping money into the stock market and sending prices upwards any more.

Thirdly, there’s a distinct lack of faith that the federal government might be able to step in where the Fed fears to tread. Indeed, the base-case scenario at this point is that the government is going to make things worse rather than better. QE2, at heart, was a monetary response to a problem much better addressed with fiscal policy; right now we have no more help on the monetary side of things, and the fiscal response has been — astonishingly — to cut spending rather than raise it.

Finally, ever and always, there’s Europe:

By failing to act decisively, policymakers have allowed the Euro-zone’s crisis to morph from the outer periphery (Greece, Ireland and Portugal) to also include much larger (and, therefore, harder to solve) countries (Italy and Spain), as well as the continent’s banking system.

Now none of these factors are exactly new, which is why it feels a little bit silly to use them to explain a stock-market drop on Thursday August 4. They were there on Wednesday, they’re there today, and they’ll be there tomorrow too. I very much doubt that some large number of institutional money managers all woke up yesterday morning in synchronicity and decided that they were worried enough about US economic growth that they should sell a significant part of their stock portfolios.

But the stock market is far from efficient at reflecting economic expectations. Remember 2007, when we were in the midst of a brutal credit crunch, the housing market was imploding, and bond markets were all but frozen solid — the stock market continued to set new all-time highs. Stocks tend to lag bonds when it comes to pricing in macroeconomic pessimism, and when they do start pricing it in, they tend to do so violently. Stocks rise slowly and steadily; they fall dramatically and with great violence. Over the long term, the slow-and-steady tortoise wins the race. But in the short term, anybody who bought stocks in the past few weeks is very unhappy right now, and has no appetite to buy more.

It’s instructive to take a step back, here, and look what happened to stocks since that 2007 high. For about a year, they slid back slowly to roughly their current levels. Then, when Lehman Brothers collapsed, stocks imploded, and kept on falling through the first quarter of 2009. That violent sell-off was followed by a super-strong year-long recovery, to, again, roughly current levels.

Think about it this way: if the S&P is trading at around 1,200, that’s an indication that the economy is going to be reasonably healthy going forwards. Nothing special, but nothing disastrous either. We got ahead of ourselves in 2007 and fell to about 1,200. Then came the financial crisis, stocks plunged, and subsequently rebounded back to about 1,200. Over the past year or so we’ve traded at 1,200ish; momentum trading and QE2 helped to push us up, and now economic pessimism is pulling us back.

If you think that we really are going to enter a double-dip recession, then stocks are not remotely attractive at these levels: they have a ways further to fall. If you think that wise and proactive economic policy in the US and Europe can help prevent such a thing, then likewise it’s a good idea to stay on the sidelines right now: there’s no chance of that happening any time soon. On the other hand, if you genuinely believe that less government is better government and that the private sector, left to its own devices, will create jobs and economic growth, then maybe what you’re seeing right now is a buying opportunity.

For most of us, however, I can only reiterate that the volatile expectations market known as the the stock exchange is really nothing to get too excited about. Over the long term, stocks are a good place to place savings — and right now they’re cheaper than they were quite recently, which is good news for any long-term savers. In the short term, stocks are unpredictable and volatile, which means that only the very brave or the very idiotic attempt to time the market and do the buy-low-sell-high thing.

Every so often, we get reminded of that unpredictability and volatility with a massive stock-market swoon. It’s probably a helpful reminder, just so long as you don’t let it worry you too much. If you want to be really worried, look at the things we’ve known for ages: that unemployment is stubbornly high, that governments in both the US and Europe seem powerless to help, and that the entire developed world is burdened with far more debt than it can ever comfortably repay. It’s the global economy which matters, not the vagaries of intraday stock-market moves.


The house always wins.

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