Despite well telegraphed intentions, the Standard and Poor’s downgrade of US Government long term debt still came as a big shock to most investors. The markets have and will continue to react accordingly. Expect high volatility and no small amount of panic.

Economist CoverWith the US economy barely growing (latest reading at 1.6% for 2Q), the next question is the one which we find on the cover of the Economist this week. The magazine and other sources like ECRI are not willing to say for sure that there will be a second recession but are warning that the chances for a double dip are on the rise. The popular image is of the US economy being like a slow moving bicycle…the slower it moves, the more easily it can tip over. Like most easy images, this one obscures more than clarifies. As the impact of the tsunami in Japan on global supply chains demonstrated, the US economy is far more complicated than a bicycle.

Earnings are pretty good

While politicians are doing their utmost to stymie growth in the US, on the earnings side S&P500 companies have turned in positive numbers. In the latest round of reporting, the earnings have grown at just under 18% or about 5 percentage points better than expected. How can the largest listed corporations in the US be earning better than expected profits with the US economy so close to “stall speed”? The magic trick is achieved by non-US sourced earnings which may account for as much as 50% of the total (up from less than 40% before the onset of the Global Financial Crisis). The developing world continues to develop a middle class that is keen to acquire the trappings of their recently improved status.

Valuations are out of line

The dichotomy between the US economy and its leading corporations is part of the reason why there has been a disconnect in the “Fed Model” which compares the interest yield on the current 10 year Treasury to the inverse of the PE ratio (otherwise known as the “earnings yield”). If 50% of the earnings used in the earnings yield calculation are from non-US sources, comparing that result with a less than free market rate on 10 year US Treasuries (thanks to QE2) is an exercise in GIGO (garbage in, garbage out) financial modeling.

What should an investor do?

In the case of risky assets, one should be watching for short term opportunities at this point. SPY is very oversold (see chart) so even though the long-term outlook is unclear, there will no doubt be a rebound as soon as the panic subsides and cooler heads move in to pick up the pieces.

SPY is oversold

Otherwise, continue to monitor the situation from the sidelines. Gold will continue to move up as investors who are extremely risk adverse will look for havens beyond short term US Treasuries. If one thinks about gold as a low inflation currency, it is not hard to fathom its latest appeal. Of the 100 largest ETFs listed in the US, IAU and GLD remain at the top of the rankings. Health Care, Biotechs and Pharmaceuticals are also found amongst the top 20 but the ratings are far from conclusive at these single digit levels.

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