Shit hits the fan – US downgrade & its aftershocks

In a sudden and dramatic move, one of the Top 3 rating agency, Standard & Poor downgraded the US from AAA to AA+. This at a time when the other two rating agencies, Moody and Fitch, had for the time being re-affirmed the AAA rating.

While theoretically this downgrae seems to be out of the blue, the fact that US markets were being pounded with the worst fall happening on Thursday with basically very little news to cause that kind of fall (other than technicals, since technically every system would have been on a Short mode well before Thursday), the downgrade is seen to have been known to atleast a few or had been anticipated by some which was the reason they were keen to exit at any price.

Since the downgrade has come after the US markets closed and with the weekend kicking in, even the futures market being shut, we can come to know of the consequences of this only on Monday morning. 

Theoretically while a downgrade hurts, in the practical sense, it isn’t that this is a kind of Satyam where everyone thought it was something else but turned out to be some thing far worse. In a way, most persons in the market knew that the US is in trouble but the fact that US is in trouble in itself doesn’t lend to making any strikingly different reasoning since with every one knowing that its bad, the market would in time would have discounted that event / matter.

So, how does this downgrade hit us is the key question that has to be answered and honestly its still too early to make a suggestion of either this being the start of a run down or it turning out to be just another hiccup. Personally I have been bearish about India in the longer term due to a variety of fundamental reasons which I incidentally was posting over the last few days on my twitter stream. 

I believe that Nifty is headed much worse than what we are currently if things go according to what I have visualized. One of the key challenges / problems for India in my opinion is that we are overdependent on IT exports. IT has been in my opinion the key driver of the economy with the benefits of it getting spilled over to other sectors as well. Take IT out of the equation by even a bit and all hell will break loose.

The reason I see a negative in IT exports is simple. The US dollar will react to this event by (in theory) depreciating against other currencies. One of the biggest edge for IT in India has been the weak rupee. If that starts to become stronger, it will erode the margins for IT companies forcing many IT projects to be taken back to the US. After all, its not that there aren’t enough IT guys in US, its just that they were unable to compete with India (and with China in the manufacturing sector) precisely because of our weak rupee.

There is a story that we are taught in our early school years – The Ants and the Grasshopper. Our government has behaved like the Grasshopper by not using the good times to build infrastructure that can last the bad times. Instead it (even now) is coming up with harebrained schemes to further expand the deficit. 

Just like the Fed has shot all its silver bullets well before this happened, so has  the Indian government here. It literally has not much of a option if Tax revenue starts to slide down. With Interest rates already high, more borrowing by the government will push it up further higher making it tough for even ordinary business to survive. Since costs will have to be pushed to the final consumer, this can have a vicious impact on inflation.

Some of this may be negated by the cheaper imports of fuel (can happen if either Rupee Appreciates or Crude prices crash worldwide) but since much of the inflation is more due to supply constraints than demand, I feel that this alone cannot soften the blow. 

While there has been great amount of talk on blood spilled on the street (market parlance to stocks bottoming out), to me, the blood spilling is yet to happen. 

 For example, if you take the CNX S&P 500 stocks, out of the 500, 337stocks still trade above the 200 day EMA. If one looks the same ratio in February / Mach of 2008, it was around the same. People who bought there too lost and maybe lost more since with the market already having fallen, many would have taken a chance to buy more than they normally buy.

For the Indian markets, I believe that a test of 4800 is a possibility that is very much higher. 4800 is not just a horizontal support line but also is the current weekly 200 day EMA. But as I said above, it depends on a lot of factors which we will know in the days to come.

Happy Trading

Prashanth