TradeSmith Roundtable: The Debt Downgrade Survival Guide

RJ Hamster

2 years ago

TradeSmith Roundtable: The Debt Downgrade Survival Guide

By now we’ve all heard that Fitch Ratings early Wednesday downgraded America’s credit rating from a perfect “AAA” to “AA+.”

The credit firm said that “a steady deterioration in standards of governance” and the mountains of debt the United States has amassed were key factors in the controversial decision.

Indeed, Fitch executive Richard Francis, the head analyst on the U.S.-credit-rating team, told CNN that the move was fait accompli.

“The numbers speak for themselves,” Francis said, noting that the country’s debt accounts for a “pretty alarming” 113% (and mounting) of U.S. economic output.

The last time America’s credit rating was squeezed like this was way back in August 2011, when S&P, another top credit-rating firm, reduced it from “AAA” to AA+. Prior to that, the United States had maintained a perfect rating since 1917, when Moody’s Investors Service first assigned America its AAA rating. (Moody’s continues to maintain that top rating.)

The 2011 downgrade came during a flinty debt-ceiling standoff — on a Friday afternoon, no less, meaning investors had the whole weekend to stew about the news.

On the first trading day that followed, the S&P 500 stumbled a painful 7%. Stocks whipsawed their way through their most volatile week since the 2008 global financial crisis. And then took six months to regain their previous peak levels.

We’ve all heard about the potential fallout from this downgrade — on everything from mortgage rates to government borrowing costs.

But I wanted us to dig deeper.

So I convened an impromptu “TradeSmith Roundtable,” that included Quantum Edge Editor Jason Bodner, Predictive Alpha Editors John Jagerson and Wade Hansen, Constant Cash Flow/Ultimate Income Analyst Mike Burnick, Derby City Insights Senior Analyst Andy Swan, and Chief Research Officer Justice Clark Litle, the voice behind TradeSmith Decoder.

The goal of this interesting exercise: Understand just what this debt downgrade means. And detail what you, as investors, should be thinking about… or looking to do.

Here’s an edited transcript of our discussion.

Keith Kaplan (Q): Mike, let’s start with you. Are we talking about a situation where: “Hey, this is overblown, and really doesn’t mean much in the near-term?” Or is it more like, “okay, folks, all the pundits and so-called experts out there are vastly underplaying this… long-term, it’s a bigger deal than they’re letting on, and regular folks need to get ahead of this?” Or somewhere in between?

Mike Burnick (A): It’s a good question, Keith. I’m not so sure the Fitch downgrade will have the same impact as 2011. I mean, with that downgrade by Standard & Poor’s, the move was a surprise because it was the first time U.S. debt was ever downgraded. This time… not so much. In fact, if you look back two months at the whole debt-ceiling fiasco, you could see this was coming. Maybe the bigger surprise is that Fitch didn’t act sooner.

Here’s some other food for thought: Back in 2011, stocks (eventually) performed well after the downgrade. SPX dropped over the summer as the debt ceiling thing dragged on. But the S&P downgrade pretty much marked the bottom as stocks recovered in the fourth quarter of that year.

KK (Q): An intriguing question about why Fitch acted when it did. And about how stocks acted the last time around.

In fact, that’s something that Jason has keyed on, am I right on that? And, true to form, you’ve got some data to share?

Jason Bodner (A): I did, indeed, Keith. We looked at stocks, and what happened in 2011. Stocks reacted much more sharply — at least initially — back then, but were up a lot from their lows just a few months later.

Unfortunately, too many investors shoot first and aim later. Anyone who sold on that initial drop was regretting it pretty quickly. The S&P 500 stayed volatile, but it got back to its pre-downgrade level within just seven trading days. And by the end of the year five months later, it rallied 12%.

The fact is that the U.S. isn’t going to stiff anybody and default on its debt. So this is like having your personal credit score drop to 750 from 800 because you took out a loan to pay for your vacation.

KK (Q): John and Wade… do you see this the same way?

John Jagerson (A): While it was surprising to wake up to Fitch’s downgrade of U.S. debt this week, there was nothing surprising in the reasons the ratings agency gave for issuing the downgrade. In fact, much of the justification felt like old news.

The 2011 downgrade didn’t trigger the [stocks] decline that August; it was already well underway as the European debt crisis was spiraling. But the similarity between the two downgrades is that S&P in 2011 and Fitch here today point to rising entitlement costs (Social Security, Medicare, Medicaid) and any credible plan for the government to deal with future spending needs.

Are these serious issues? Yes. However, investors tend to undervalue long-term problems and overvalue short-term events. So, while we agree that the downgrades point to real problems in the future, those problems are unlikely to stay in the aggregate investor consciousness, since the time horizon is longer than a few months.

Wade Hansen (A): Keith, Wall Street has been watching politicians in Washington D.C. push negotiations on things like the debt ceiling and funding the Federal government right up to, and sometimes even past, the understood deadlines — for decades now. This is nothing new. Sure, the ferocity of the disagreements between the two sides ebb and flow from year to year, but the pattern continues to play out largely the same. Negotiations drag on until the last minute, and eventually, a deal is struck.

JJ (A): It is also true that government debt is becoming more expensive as interest rates rise. But this is also old news. Everyone, except for those who were in the risk department at Silicon Valley Bank, has seen this risk unfolding in the bond market for nearly two years now.

So is the Fitch downgrade important? Yes, it is.

In the short term, the market will have some knee-jerk responses to the news that are going to take a few weeks to fully play out. However, we don’t see this as a serious spoiler for market returns this quarter. And in the long term, this makes it a little easier for other ratings agencies to follow suit if they see risks rising, but it is not likely to impact the financial markets in any way you could discernably attribute to the downgrade.

KK (Q): Justice, I know that you shared a unique “take” on this with your Decoder readers. Could you share it again here?

Justice Clark Litle (A): Absolutely, Keith.

So, the Fitch downgrade, while not actually creating a problem for the dollar or U.S. Treasuries longer term, is very much a problem in the short-term to the degree it forces stock-market investors to wake up to the fact they are living in a dream world, and [that] the forward trajectory for stocks from here is a nightmare. The U.S. dollar, meanwhile, is likely not only to keep its dominance in the years to come but increase that dominance over the global financial system to an even larger degree.

KK (Q): Because…

JCL (A): Because of an increased occurrence of energy-and-food-price spikes that emphasize the extraordinary relative strengths of the United States vis-a-vis a far more vulnerable rest of the world.

KK (Q): So for everyday investors, what’s the strategy here?

Andy, what does the system you use at LikeFolio tell you here?

Andy Swan (A): Well, Keith, I didn’t need a “downgrade” to tell me the U.S. debt situation is problematic… and that there are only two ways out of this: Federal fiscal responsibility OR inflate it away. History tells us it will be the latter.

And here’s where it gets interesting from an investment point of view.

KK (Q): With crypto?

AS (A): For starters, yes. Bitcoin’s initial reaction to Fitch’s downgrade — by moving higher — was a “tell.” Bitcoin (BTC) is becoming an instinctive target for institutions seeking safe harbor. And those long-term fiscal challenges I just mentioned… they could boost Bitcoin’s appeal.

As a decentralized currency not tied to any country’s fiscal policy, Bitcoin could be seen as a safer long-term investment.

And the opportunities don’t end there. At LikeFolio, we really don’t care much about “headline events” like this one — or moves by the Fed. Our “edge” comes from understanding consumer behavior — what “real Main Street people” are doing — before it becomes news on Wall Street.

We can always find big profit opportunities in individual companies… especially with an AI-driven tool like the Social Heat Score that can predict when a stock is ready for liftoff. We built the device ourselves, and when we see a Social Heat Score of 70 or more, we know that’s a bullish pick. Coinbase (COIN) is registering an 89 right now. Out of 100, that’s a great bet. And it makes sense: If Bitcoin does well, Coinbase does well. And as I was just saying, we see Bitcoin doing very well from here.

KK (Q): Jason, what are you thinking about/looking at here?

JB (A): The bottom line — for me — is that this downgrade reinforces my outlook for seasonal volatility here in August and in September. It doesn’t really change my thinking or my strategy. If anything, it underscores the importance of my approach to stock-picking — which helps us be sure to make investment choices based on data, not emotion. Think about an airplane pilot flying through thick fog. You can’t see the horizon. So you rely on the gauges on your instrument panel to keep flying toward your destination. They provide certainty. If you take your eyes off your instrument panel, you no longer have reference points. You risk spatial disorientation — and a crash.

In an uncertain market, data serves the same purposes as airplane navigation gauges in the fog: You stay on course, avoid the disorientation of emotion, and navigate your way to safety.

KK (Q): A nice example. And some clarity about what you see… despite the uncertainty.

John and Wade? Flesh out your scenario… and explain how investors should respond.

WH (A): Again, we expect to see some short-term volatility. But that volatility should give investors opportunities to buy some of the high-flyers on the dips.

Using artificial intelligence to identify momentum opportunities will give investors an edge, as well, as prices are likely to move back and forth quickly over the next few weeks.

JJ (A): That’s right. The downgrade also reinforces some of the long-term investment themes we recommend investors monitor. If government debt continues to become more expensive, then the bond market — or, at least, “investment-grade” bonds — should still be an underweight portion of a portfolio. Inflating assets like stocks — and even real estate, despite rising rates — looks like the best way to hedge against long-term uncertainty while hiring and spending trends remain positive.

KK (Q): Awesome stuff, guys. And you’re absolutely on point about AI, which is the hot topic with investors right now… but that’s also a key piece of the software we’ve built here at TradeSmith… and that’s central to the predictive analytics you and Wade use to such great effect.

Let’s turn to you, Justice. In your view, what are investors looking at here?

JCL (A): No matter what happens… the stock market winds up losing because current equity-market valuations are beyond ridiculous. As of July’s end, the S&P 500 was trading at 26 times price-to-earnings; in recession conditions, it should be trading closer to 15 times earnings with a lower dollar volume of earnings to boot, implying a 50% drop. That in turn means that, if the bond market is right, the stock market could get cut in half from here; if the bond market is wrong, on the other hand, bond prices are going much lower, and yields much higher, as a result of either economic normalization or a supply-and-demand-driven boycott of government spending run wild.

TradeSmith Roundtable: The Debt Downgrade Survival Guide

Here’s an edited transcript of our discussion.

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