The main story of the day was that Standard & Poors kept US government bond ratings at AAA, but cut its outlook from stable to negative. This sent stocks tumbling out of the gate to as low as Dow 12,093 before bouncing over a hundred points. Yet even that finish was still well into the red.

Personally I am shocked and dismayed by this reaction. Why? How could anyone think that our debt situation was actually in good shape??? In fact, how is it still AAA and not lower?

I assumed, falsely I now see, that everyone with an IQ above room temperature was working off the same premise that our deficit was raging out of control. And that, my friends, provides a valuable investing lesson. Don’t assume anything. Because as they say, when you “assume” you end up making an “ass” out of “u” and “me” 😉

My strong hope and desire is that this truly lights a fire under our politicians to make aggressive deficit cuts soon. If not, then our debt ratings will drop while interest rates go higher. This will make financing the debt all the more difficult and wreak havoc on the economy. If we can show resolve to reign in our bad ways now, then this economic recovery can stay on track with stocks moving higher.

This last paragraph set the stage for one of the more interesting side stories of the day. When the news first came out, bond rates soared and the investors shorting government bonds (like myself) celebrated. Then as the day progressed, rates headed lower and these once profitable positions actually ended in the red.

How the heck can that be?…you ask. Because there were two competing equations at work:

Equation 1: Lower Bond Rating = Higher Risk to Investors = Higher Rates.

Equation 2: Lower Bond Rating = Higher Risk to Investors = Higher Rates = Economic Woes = Recession = Lower Inflation = Flight to Safety = More People Chasing Bonds = Lower Bond Rates.

As you can see the initial reaction was based upon the shorter version of the equation. But as some investors played it out further, they added on the other components.

This truly is the $64,000 question and I could see how both are real possibilities. However, the way the equation has played out with other, recent debt -ridden nations (Greece, Ireland and Portugal) is more like this:

Equation 3: Lower Bond Rating = Higher Risk to Investors = Higher Rates = Economic Woes = Recession = And Rates Stay High (because investors need a higher rate of return given the default risk on the debt).

Oh, but wait. It could be…

Equation 4: Lower Bond Rating = Higher Risk to Investors = Higher Rates = Government Forced to Get Their Act in Order = Higher Rates than Now…but not too high to derail economy.

And that is the one I am banking on now, which is why I am still long stocks. However, if equation #3 starts to unfold, then we will need to get more defensive as a weakening economy/recession = tumbling stocks.

When you add it all up, I expect volatility to be on the rise as investors struggle to compute which equation will prove out. I will keep my calculator in hand to keep on top of the situation for all concerned.

 
Zacks Investment Research