It’s been two full market days since S&P cut the debt rating of the United States one notch from AAA to AA+… and for one day at least, it was looking like S&P had the stock market by the nose. Two days later we can finally take a look back at what happened since we’ve had two trading days, a rest in between, a Federal Reserve statement, and a speech from the President. To wit: the S&P 500 Index closed at 1199.38 on Friday, 1119.46 on Monday and 1172.53 on Tuesday.
Bond Yields
Since a ratings cut signifies a reduction in the ability of a debtor to pay back a debt, markets reacted in the opposite direction of the spirit of the cut. On Friday, August 5th, the yield on the benchmark 10 year note for the United States was 2.58%. Yields have since dropped, first to 2.40% on Monday and then again to 2.20% on Tuesday. To be fair, S&P first warned of the potential for a ratings cut on July 14, and yields were 2.98% on that day. To be even more sure I am being fair, S&P’s counterpart Moody’s first said it could put the US on review way back on June 2nd… and 10 year yields closed at 3.04% that day. So, to summarize, since the ratings agencies have been warning on US debt and after one of them actually cut the United States’ debt rating, the United States has had to pay even less to finance its debt.
In effect, investors, in a panic, are fleeing US Debt to buy… US Debt.
Stock Market
The stock market is something else entirely. I agree wholeheartedly with Ironman at Political Calculations when he states that the market fall was merely noise. I’ll take it a step further: something has got to give. Either bonds are overvalued or stock is undervalued, or some combination of the two. One metric that has gotten wildly out of wack is the spread between the earnings yield (the reciprocal of the price to earnings ratio) of the stock market and the yield on 10 year United States debt (known as the Equity Risk Premium).
Yahoo! Chart for the S&P 500, 5 Days leading up to 8/9/2011
One way to quickly get the approximate P/E of an index is to find the P/E ratio of an ETF which tracks that index. Take SPY, for example, the very well known SPRD S&P 500 ETF. SPY has a P/E of around 14 (so the S&P must be around that number), giving us an earnings yield of 7.14%. Taking the 10 year note’s close today of 2.20%, the spread is a whopping 4.94%. That’s the highest it’s been in a generation. There are a few ways for this to come back down to earth: bond yields rise, stock prices rise, or stock earnings fall (or some combination of the three). However, unless “This Time Is Different“, something is going to change to bring these numbers into balance.
