Last week we saw Fitch Ratings downgrade U.S. debt from AAA to AA+.  Am I the only one that laughs and is confused by this rating system?  The market sold off hard and had one of the worst declines in months.  The next day we had Treasury Secretary Yellen and JPMorgan CEO Dimon downplay the announcement, but that did little to bring stability back to the market.  So the question is, what really happened and where are we likely to go from here?

John Hutchinson has been writing about the S&P 500 valuation based on projected earnings and he has mentioned that the index is pricing in nothing bad happening.  Analysts are bullish and most have been hyper-focused on the inflation story that prices of stocks have crept higher into expensive territory.  The volatility index (VIX) as shown below is also telling us that investors are complacent with their overpriced stocks.  Volatility has decreased over much of the past year.

The high valuation has left this market vulnerable to any economic surprise, like an announcement about a downgrade in U.S. debt.

So, should you indeed be worried about the Fitch announcement? I don’t think so. We’ve been talking about a healthy pullback for some time now, but the velocity of any such pullback is likely to be more profound due to stock valuations and the relentless rally, especially in tech.

Why am I not worried about the downgrade?

Look at what happened the last time the U.S. Credit was knocked off its high horse in late 2011.

The S&P 500 fell short in August and September (sound familiar?) after the announcement, but it eventually rose up like a phoenix through the ashes and climbed 16% higher a year later.      

Earnings and valuations are the real story, not the miscellaneous headlines.

Jeff Wood
Editor, Filthy Rich Dirt Poor
Coach, Options Testing Lab

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