American Investment Services, Inc.

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Aug. 2011 – Lessons from the Downgrade

On August 5, after markets had closed, Standard and Poor’s stripped the U.S. of its triple-A rating. Many had predicted that a downgrade would result in a broad sell off of Treasuries and a corresponding increase in yields. These predictions proved to be wrong. The next trading day, August 7, the yield on the 10-year Treasury note fell from 2.56 percent to 2.34 percent, and three days later the Treasury sold $24 billion in 10-year notes at a yield of 2.14 percent, the lowest on record.

These forecasts overlooked the nature of markets, or more specifically, the fact that investors are forward looking. Prices reflect information as it becomes available, and the market had already discounted the potential for a downgrade. Prior to Standard and Poor’s formal announcement, it was hard to avoid media speculation regarding a downgrade and the impact it might have. The subsequent fall in yields was in reaction to new information; in this case bad news from Europe emerged before the market reopened, which drove investors to flee stocks in favor of the perceived safety of U.S. Treasuries.

This episode is instructive not only for investors, but perhaps also for Congress and the President. Now that agreement has been reached regarding the U.S. debt ceiling, debate has shifted to what the federal government might do to spur economic growth.

Many are calling for even more government spending in order to create jobs and boost household income. In theory, such “pump priming” will increase aggregate consumer demand, which in turn will spur business investment and further expand the workforce. But consumers, like investors, are forward looking and react to news as it emerges. Households may in fact refrain from spending to the extent they conclude that higher deficit spending by the government portends lower private sector investment or higher taxes in the future.

Individuals acting rationally in their own self interest invariably confound prognosticators on Wall Street and planners in Washington, who hope to predict or control the future. Our recommendations, by contrast, do not second-guess the wisdom of free markets.

Also In This Issue

Thinking In Real Terms
Gold: A Tale Of Two Decades
Gold And Price Inflation
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow Jones Industrials Ranked By Yield
Recommended Investment Vehicles