02/06/13   U.S. Charges S&P With Alchemy

Editor’s Corner

Ron Rowland

The U.S. government filed suit against Standard & Poor’s Rating Service this week for its role in the subprime mortgage debacle.  The government is charging S&P with dragging its feet on downgrading hundreds of securities even though it knew the housing market was collapsing.  The credit ratings industry has always been fraught with conflict of interest because ratings are typically initiated and paid for by the issuer.  As such, ratings agencies risk losing a paying client if the securities of that client do not receive a desirable rating.

U.S. Attorney General Eric Holder accused S&P of rampant fraud and egregious conduct that goes to the very heart of the financial crisis.  The $5 billion being asked for is roughly equal to the past seven years of earnings for McGraw-Hill (MHP), S&P’s parent company.  Federal prosecutors began their investigation in 2009 under the codename Alchemy, a term often associated with trying to turn basic metals into gold.

Both sides appear to be girding for a long and non-traditional legal battle.  S&P typically defends its ratings as opinions protected by the First Amendment, but the company indicated it will likely pursue a different strategy this time, starting with the fact Moody’s and Fitch issued the same ratings.  Don’t be surprised if S&P puts the blame right back on the government.  After all, S&P’s views on the housing market were no different than the views of various government agencies.  Additionally, regulators were complicit in allowing the “pay for ratings” business model to exist and thrive in the first place.

We hope you are enjoying your brief vacation away from the budget antics of Washington.  However, vacation time is over, and budget talks, sequestration, and finger pointing are now returning in full force.  The last minute deal to forestall the fiscal cliff bought lawmakers more time, but time is again running out.

The respite was great while it lasted, and stocks enjoyed the January sunshine.  Clouds of uncertainty are starting to build as budget proposals swing one way and then another.  The ultimate impact this will have on stocks is unknown, but we wouldn’t be surprised if the current uptrend starts to get wobbly.  There’s still hope a compromise can be achieved, but for now, both sides seem determined to dig in their heels.

Investor Heat Map: 2/6/13

Sectors

Industrials kept its grip on the top spot.  The Financials sector is still relegated to second place, although the gap between it and Industrials has now been eliminated.  Energy continues to climb the rankings, moving up one position to third today.  Health Care is also gaining strength, jumping into the top half and pushing Consumer Discretionary down to fifth.  Materials occupies the mid-way point today and lost strength the past week despite the strong showing for raw commodities.  The lower half of the sector rankings consists largely of defensive and income-oriented groups.  Consumer Staples moved ahead of Real Estate, and Telecom moved ahead of Utilities.  Technology is on the bottom again and has been unable to mount a meaningful rally.

Styles

The Style Edge Chart is displaying an interesting pattern today.  It suggests that domestic stocks are quite strong, and participation is much more important than selection at the present time.  A majority of the green strength bars are at indistinguishable levels.  There are just a few laggards, and underweighting them is producing better results than trying to overweight other Style categories.  Still, there has to be a category at the top, and it is Mid Cap Value again this week.  The near 7-way tie for second place consists of the other two Mid Caps, the three Small Caps, Micro Cap, and Large Cap Value categories.  Large Cap Value managed to sneak its way in amongst the Small and Mid Caps.  However, the market has been favoring Value over Growth for many weeks, and it is the Value component that is separating it from the other Large Cap and Mega Cap laggards.

Global

Europe’s lead is fading fast.  Barring a huge upside rally that outpaces the rest of the world, Europe will likely fall far in next week’s rankings.  EAFE and Pacific ex-Japan both moved up a spot as China fell from second to fourth.  China and Europe have been leading the Global rankings for some time, and both are now experiencing short-term weakness.  It is too early to determine if this is a temporary pullback, the start of a new downtrend, or just a change in leadership.  The U.S. continues to climb up the rankings, making its case for the “change in leadership” scenario.  Japan is also vying to be part of a new leadership story.  It has been volatile this year, but the trend is to the upside.  When the negative effects of a weakening yen are removed, then Japan’s market trend is much smoother and stronger.  If our Global rankings disregarded the currency effect, Japan would be on top.  Latin America and the U.K. both moved down the list as Japan climbed ahead of them.  Emerging Markets and Canada occupy the bottom two slots again this week.

 

Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

 


“S&P’s desire to ensure market share led it on a misguided venture to take securities it knew were lead and to tell the world through its ratings that they were gold.”

David Tony West, acting associate attorney general, U.S. Justice Department, 2/5/13


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