Friday, August 12, 2011


From the Desk of Joe Rollins

There was a massive selloff on the stock market on Monday due to the reported S&P downgrade of the American credit. This action by S&P defies any practical explanation, and the selloff in the equity markets is even further suspect. To give you some point of reference, I will try to explain what should have happened as compared to what actually did happen.

In theory, if someone were to downgrade your ability to repay your debts, under every situation I can think of, the borrower would be required to pay higher interest rates in order to obtain the debt. If I am a lender, I certainly would want higher interest rates to compensate for the possibility that the borrower would not or could not repay me when the debt becomes due. Over the weekend, when S&P downgraded the credit rating of the United States, presumably, we should have had seen higher interest rates, but that is almost exactly the opposite of what happened.

When news of the downgraded credit was announced, interest rates did not skyrocket, they plummeted. On Monday evening, the ten year treasury note was at 2.37% which is very near the rate of inflation for the ten year cycle. This move from equities into Treasuries is totally without any type of financial basis.

To illustrate my point, a few quotes from Warren Buffett seem to shed light on the matter at hand:

“Our currency is not AAA, and in recent months the performance of our government has not been AAA, but our debt is AAA.”

“I can go out drinking all night, but if I've got a printing press, my debt is good.”

“If anything, it may change my opinion on S&P.”

There is no conceivable way the United States could ever default on its obligations. If the day came when there was zero money to pay the debts, the Federal Reserve could simply print up some new money. Of course that would create massive inflation and would put us close to the definition of a banana republic. Even though S&P made a “slight” $2 trillion arithmetic error (caught by Treasury officials and acknowledged by S&P) when they downgraded the debt of the United States, any thought that there would be a default by the U.S. government is almost ludicrous. Furthermore, we are talking about the second highest rating of only one of three credit agencies. In fact, last Tuesday in light of the debt ceiling deal, Moody’s confirmed their AAA rating for the U.S. debt.

I was also amused by Buffet’s retort regarding the S&P. Not that it has anything to do with finances, but Buffett reminds me so much of Sir Winston Churchill in his later years. I love to quote Churchill in his short and witty responses. My favorite is from the time a belligerent dinner partner of Churchill exclaimed in a loud voice for everyone to hear, “Winston you’re drunk!” Sir Winston’s quick response was, “Madam, you’re ugly, but tomorrow I’ll be sober.” And, now that I think about it, that does describe the equity markets from one day to the next.

What also got my attention was a segment from a press release from Goldman Sachs. I am positive that Goldman Sachs was right in the middle of the massive selloff when their research department put out a notice that they were reducing their year-end target for the S&P 500 Index stocks from 1450 to 1400 due to lower GDP growth estimates. On Monday, the S&P Index closed at 1,119. Whether you realize it or not, Goldman Sachs was telling you that they believe that from now until the end of 2011, they expect the S&P Index to rise 25%. Despite the irrational selloff in equities on Monday, Goldman Sachs is reinforcing that the investing public will return to caring about what is really important - earnings.

Yes, we have received some calls in the office from clients expressing concern. Who would not be concerned when you have a completely dysfunctional government with zero leadership in the White House? However, I am a true believer in the glass half full approach. The economy, while weak, is certainly is not a 2008 economy. Interest rates cannot get any lower, and the price of oil has plunged 20% in just the past month. The reduced cost of oil and interest rates nearing zero have produced two major stimulants for our economy - lower gas prices and lower mortgage costs. With these two stimulants and without governmental intervention, it would seem to me that the second part of 2011 may even better then the first half of the year.

In another segment of the Goldman Sachs press release, they indicated that they were lowering 2012 earnings estimates for the S&P 500 from $104 to $102 per year. If you use Greenspan’s calculation of fair value of the S&P that I discussed in my post on Saturday, August 6th, using the new estimate of $102 and the ten year treasury at 2.37%, the fair value for the S&P 500 would be 4,403 (350% above of today’s level). While those numbers are obviously ridiculous due to the low interest rates, I think it magnifies an important point. Notwithstanding the enormous volatility and the inadequacies of our government, earnings have not changed, and they will most likely stay at elevated levels through 2012.

It is highly likely that the market, once the current volatility passes, will return to its slow but steadily increasing path until the end of the year. In light of all of the current activity, I still maintain my estimate of a 10% return on the equity markets for 2011. It is nice to know that Goldman Sachs agrees with me.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins