The Downgrade and Market Volatility

Last Friday, Standard & Poor’s, one of the two largest rating agencies, lowered the credit rating of the U.S. Government from AAA (the highest level) to AA+ (the second highest level). Their stated reason for the downgrade was concern over the size of the budget deficit. While this move was expected by many analysts, the U.S. stock market incurred a price drop of 2% at the opening of today’s market, in part because of uncertainty caused by the downgrade.

What does this mean for you? Actually, not that much. Interest rates might be slightly higher going forward, but the increase will not be too large because many analysts expected this downgrade, and most institutional bond managers do their own credit analysis and do not pay attention to credit ratings. After today’s initial decline in stock index levels, we do not think there will be additional impact on stock values.

Our belief is stock prices will be more volatile than normal over the next few days. You will likely read in the press that this heightened volatility was caused by the downgrade. Actually, the increase in volatility was caused by last week’s price movements and not by the downgrade. To see this, we analyzed the stock market reaction over the several months following a significant daily price decline (defined as greater than 4%). As you can see from the graph below, average volatility rises significantly immediately following a price decline, and slowly settles down over the next several months. So the volatility that occurred on Friday, and the daily price fluctuation you will likely see this week, is very typical.

Average Stock Market Volatility Following a Significant Daily Decline

Does this mean you should exit the market? No, because the fluctuations are as likely (or maybe more likely) to be on the upside as they are on the downside. On the next page is a graph that shows the average growth of a dollar invested in the stock market following a significant daily price decline compared to the typical growth of the stock market. The stock market actually earns above average returns over the few months following the decline.

Stock Market Growth Following a Significant Daily Decline

Selling immediately after a market decline does two things:

1) On average, it causes a “buy high, sell low” effect, which hurts your long-term performance

2) It takes you off of your long-term investment strategy, actually causing greater risk of not obtaining your investment goals

Consequently, we recommend that you keep your eye on the finish line, and not react to short-term price movements.


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