Spain's bond market ignores the downgrade

(MoneyWatch) 

Standard & Poor's downgrade of Spain's long-term credit rating was met with a collective yawn by investors. History shows that the lack of reaction should have been expected.

On Friday, S&P downgraded Spain from AA- to A with a negative outlook, due to the deepening of the eurozone crisis, with S&P noting that the move "reflects our opinion on the impact of deepening political, financial and monetary problems within the euro zone, with which Spain is closely integrated."

I'm sure most investors expected the downgrade of Spain's sovereign debt to cause Spanish debt yields to rise and European stocks in general to fall. Yet, on Tuesday, Spain's Treasury successfully raised 4.9 billion euros ($6.2 billion) from its auction of 12-month and 18-month bonds with yields of just 2.15 percent and 2.49 percent, respectively, the lowest since October 2010. The same bills fetched borrowing costs of 4.09 percent and 4.25 percent in December, and yields have fallen in four straight auctions. And despite the downgrades, both European and U.S. stocks rallied early in the week.

Perhaps S&P's ratings don't matter. Or perhaps the markets believe the eurozone quagmire is fixed. Or perhaps the market had already built worse assumptions into prices. Perhaps the fact that the European Central Bank is now providing three-year loans to member banks at 1 percent, as long as they use the funds to purchase EU debt in the auctions, has successfully addressed the market's concerns about bank liquidity. There's no way to know exactly why the markets rallied. However, there are important lessons for investors.

First, it's totally irrelevant to market prices whether news is good or bad. All that matters is whether the news was better or worse than already expected. What's expected is already built into current prices.

Second, when the news is bad, investors should anticipate that governments and central banks will address the problem. And the worse the crisis, the more likely they'll act with a sense of urgency, and the scale of the actions will be proportional to the problem. One would think that the Federal Reserve's actions over the past few years would have taught investors that lesson. What we don't know, of course, is whether the actions will be successful.

Investors who panic and sell in reaction to bad news tend to remain in a vicious cycle of allowing fear to cause them to sell low (when expected returns are high), then waiting for the "all clear signal" to buy (when valuations are higher and expected returns are lower). Buying high and selling low isn't a prescription for investment success.

The best way to avoid this problem is to have a well-developed plan and stick to it, rebalancing along the way. Doing so causes you to buy low (after periods of relatively poor performance) and sell high (after periods of relatively strong performance). Buying low and selling high is surely a better strategy than the reverse.