18 August 2011

Wall Street ... Huh?

In four wild days on Wall Street last week, August 8th to August 11th, the indexes went on the most jagged roller coaster ride they've had since anybody has bothered keeping indexes.  A record down day Monday, most of that gained back Tuesday, the gains lost again on Wednesday and re-conquered on Thursday.  The only time in history there have been moves of 400 points or more in each of four trading days, and they all came in alternation, as if the charts wanted to create their own "W".

What was going on? 

One possible theory is that this was all a reaction to the S&P downgrade of US Treasury debt instruments.  How could both the ups and the downs be a reaction to the same event?

On this theory, Mr Market himself was having a tough time making up his mind whether the S&P downgrade was a big deal for him.  This should certainly caution folks such as yours truly against professing our own dogmatic views on that.  After all,  according to some theorists, Mr Market is an idealized model of efficiency and rationality.  Nobody has ever said that about me!
Actually, false humility aside, my guess is that the downgrade a medium-sized deal, and it could become a big deal yet. Last week's wild "W" could reflect that.   

There are lots of pension funds and other institutional investors out there with AAA mandates of one sort or another.  This might be a charter clause or by-law, or it might be a Labor Department regulation, but for one reason or another, a given pension manager may be required to keep at least X% of the portfolio in AAA bonds. It makes a great deal of difference whether the US Treasury bonds help satisfy that mandate. If they don't, then demand for US bonds could take a serious hit, forcing yields up, with nasty consequences either fiscal or (if we choose to monetize it) inflationary.

But ... it is my impression that most of these asset managers are allowed to average out the ratings.   If you were taking three course in school and had an A from two professors and a B+ from the other one, what would your average grade be? It would still be "A."

Since two of the major rating agencies still say AAA and the other one says AA+, the US Treasuries have an average rating of AAA, and even the asset managers with the most conservative of mandates can still buy them.

The S&P downgrade puts us a big step closer to the moment when THAT might change. The next downgrade -- either a step further frm S&P or down to AA+ by Fitch or Moodys, would be an average changer, which would in turn make it a game changer.

Thus: this is a medium deal because it could be a step toward a really big deal event.

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Knowledge is warranted belief -- it is the body of belief that we build up because, while living in this world, we've developed good reasons for believing it. What we know, then, is what works -- and it is, necessarily, what has worked for us, each of us individually, as a first approximation. For my other blog, on the struggles for control in the corporate suites, see www.proxypartisans.blogspot.com.