Farr: What the Markets Hate Most

One of the first things investors learn after “buy low and sell high” is that markets hate uncertainty.

A downgrade of the sovereign debt of the United States of America creates a profoundly uncertain condition.

More than anything, we have never experienced it before.

While we can look to other economies that have endured downgrades, the US, as home to the world’s reserve currency, is different. But, we are not sure just how different because we’ve never done this before.

I’ve been reading all weekend and am feeling a little punch-drunk from so many major stories, events and analytical reports.

• Jean-Claude Trichet heads the European Central Bank (ECB) and has pledged to “actively implement” bond buyingto shore-up and limit the contagion of Italian and Spanish debt. This “lender of last resort” is a new role for the ECB. It is seen as a very risky, “shock-and-awe” effort. Many fear it will be a type of Quantitative Easing that will risk meaningful inflation.
• The US downgrade has been widely expected and therefore, I thought, priced in to current market levels. I was wrong. Dow Jones Industrial Futures were down around 240 points and Asia is down over 2%. (Real Time: CNBC's Markets Page) The reaction in the bond markets, however, has been starkly different. Yields on US Treasury bonds are actually down this morningas investors continue to seek a safe haven. This reaction to the S&P downgrade is counterintuitive, but that’s the world we’re living in.
• The US political deal to raise the debt ceiling but promise to slow the rate at which we careen deeper into debt is a partial solution that leaves a multitude of questions unanswered – not the least of which is any specific prescription for spending on Social Security and Medicare. This Congressional debate will continue as bitterly as ever and will have deadlines that, if missed, will cause draconian consequences. Look for more market-jarring ugliness.
• The dollar is falling. (Real Time: CNBC's Currencies Page)
• The interest rate on the 10 year Treasury Note is 2.47%.
• Employment data were mildly positive but insufficient to remedy the 9% + unemployment rate at any point in the foreseeable future.
• The Fed will not increase collateral requirements because of the downgrade and will continue to finance treasury and other positions as before.

From my perch, the week ahead appears to hold more unpleasantness and may be similar to last week. I think the Fed would be well advised to sit tight for a while (interest rates have moved much lower on their own). Oil is fallingwhich will help the average consumer at the pump and for the upcoming heating season. Interest rates are as low as they have been at almost any time in history. Corporate balance sheets are strong and dividends are attractive.

Though I continue to believe that housing prices will move lower, I’m beginning to see tentative elements of stabilization. Nothing portends a swift or easy recovery in my judgment. But the elements are coalescing.

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When the Euro was adopted, I wrote that it was a really bad idea. To my simple understanding of economics it made no sense that countries could collectively surrender control of their monetary policies. Moreover it seemed illogical that a Central Bank could manage a group of economies without control of BOTH monetary and fiscal policies. Collective monetary policy without collective fiscal policy looked like a train-wreck in the making. I’m still not sure how the Euro survives, but I suspect the European Union will look a good deal different over the next few years.

Despite lots of countries and entities pledging support and faith in our US credit worthiness, our national spending that dramatically exceeds our income is unsustainable, and we continue down a path toward certain insolvency if not stopped. While encouraging words are nice, they change our impossible condition not a whit.

As we forecasted, Congress’s action to extend and defer avoids the urgent crisis and has guaranteed a prolonged debate. Unlike the past several months, investors don’t appear inclined toward additional distractions and may roil and fret over the less predictable political debate as it intensifies.

Our economy, like any, will begin a healthy expansive phase only after it has adequately contracted (and probably over-contracted). While this is normal, sovereign debt crises, regime changes in North Africa and the Middle East, threats of terrorism, American troops struggling, tsunami recovery, and more; make things look much less normal this time (and not for the better).

Investors on the sidelines should have their stock shopping lists at hand. Things are getting scary enough to do some buying. Warren Buffet says to be greedy when others are fearful. Buffet began buying more stocks last quarter. Take a look at CNBC, it’s sounding pretty scary.

Farr, Miller & Washington has been accused of over-cautious negativity for most of 2011. Our current circumstances are precisely why. It’s a tough result to feel too good about. We are looking to add cautiously and deliberately to positions on weakness and initiate some new positions as prices move lower.

I believe in America and have every confidence that we will get through this difficult time and prevail as we always have. It won’t be easy, but America will do it.

Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.