C.M.O. 8.15.2011

If you were in New York City and thinking about packing the family into the car for a road trip vacation and your destination was, say, Annapolis, MD (about 175 miles away) would you get there by way of  Phoenix, AZ (about 2,133 miles away)?  Even with the price of a gallon of gas under $4 a gallon your answer would most assuredly be, NO.

Sparked by S&P’s downgrading of Uncle Sam’s long term I.O.U.’s the Dow Jones Industrial Average went on a road trip of its own last week traversing 2,133.59 points only to land up just 175.59 points lower after all was said and done.

Yes, the White House traded barbs with the rating agency about a $2 Trillion rounding error but in reality S&P didn’t say anything anybody didn’t know already, which is that when your outflow exceeds your inflow your upkeep becomes your downfall.

In general the raters have been playing catch-up since they were the last to know that dross they gave their highest ranking to was, well, dross in the build up to the credit  crisis.  Starting with the initial downgrade of Ireland on December 17, 2010 the rating agencies seem to have done little more than fuel the speculative fire on the way down in the same way they stoked it in the years leading up to the collapse of the housing market.

Statistically speaking from a Sovereign standpoint the numbers bear out the ineffectiveness of their efforts.  The WSJ this week revealed that “of the 15 government defaults S&P has tracked since 1975, the firm rated 12 of the countries single-B or higher one year before the event.”  The irony here is that S&P itself says that equates to just a 2% average chance of default in the next 12 months.  So being wrong 12 out of 15 times puts S&P’s batting average at 200; hardly Cooperstown material.  Moody’s does worse, if that can be believed, as they missed on 11 out of 13 Sovereign defaults for a batting average of an underwhelming 154.

Adding to the irony last week, the volatility caused by the downgrade pushed everyone into newly downgraded Treasuries with the 10-year note trading as low as 2.033% breaking through the floor set in December of 2008.  The two-year note, the one most affected by the Fed’s rate (not rating) policy traded at a yield of 0.191% on Friday as a result of Ben Bernanke’s promise to keep things at zero until 2013.  It should also be noted that 22 of the 30 stocks in the Dow Jones Industrial Average now pay a higher dividend yield than Uncle Sam does on his 10-year paper.

While Ben can only put his thumb on the scale at the short end of the curve there are many that believe this will push investors tired of earning nothing out to the longer maturities in hopes of earning at least something.   Eric Green, managing director for U.S. rates at TD Securities is one such person and believes that long-term rates “are nothing more than a long-term compilation of expected short rates and an inflation premium.”

With that said the auction of $16BN 30-years notes on Thursday garnered the lowest level of “indirect bidders” since February of 2008 and was characterized as “quite horrific” by John Canavan, fixed income analyst at Stone & McCarthy.  John went on to say “Not only were indirect bids nearly non-existent, but dealer bidding wasn’t anything special either.”  “Indirect bidders” is auction speak for foreign buyers in case you were wondering.

Ironically, while the Treasury can’t sell 30-year paper The University of Southern California and our national neighbor to the south, Mexico, were able to hawk hundred year paper last week.  UCLA sold $300MM of century paper and Mexico reopened an $1BN issue from last October.  Adding some weight to Eric Green’s analysis, Scott Colyer, CEO and CIO of Advisor’s Asset Management said, “I think 100-year paper could potentially become popular if the yield hunger continues out there”.

One counter to the reach for return appears evident in the high-yield market as investors have pushed the yield premium to and average of about 739bps over comparable treasuries.  This is not at the 1000bps level seen during the 2001 recession but still about double the levels seen earlier this year.  The problem in the junk-bond market is that “high-yield companies traditionally don’t do well when GDP is below 2%”, according to Julianne Bass, a PM at USAA with $1.6BN under management.  Even in this environment, however, Michael Anderson, a high-yield analyst at Citigroup has found approximately 45 credits that are pegged to “cross-over” to investment grade in the near future.

With uncertainty high it is sometimes good to listen to those who’ve been there before and who better to ask than the gentleman who has been walking randomly down Wall St. since 1973, Burton Malkiel.  Burt wrote a piece for the Op-Ed section of the WSJ on Monday, before a relatively relaxed random walk turned into pure chaos, saying that “This is not the market meltdown of 2008 all over again.  And panic selling of U.S. common stocks will prove to be a very inappropriate response.”

In a less random way Larry Fink, CEO of BlackRock was the subject of Barron’s CEO Spotlight this week and while Larry believes “The markets world-wide are unsettled because of inaction and really bad results from government”, his advice to investors is that “they need to look beyond the volatility and the noise.  They should be re-risking, not de-risking.”

With a schedule that includes two weeks of travel every month and visits with governments and central banks as well as running a firm with $3.7TN of assets, Larry would seem to have a pretty unique view of the world.

Maybe one worth listening to.

Enjoy the week.

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