How to Invest on the S&P Downgrade of U.S. Debt

BOSTON (TheStreet) -- Standard & Poor's move to lower the company's outlook on the long-term rating of the U.S. sovereign debt to negative may have caught investors by surprise, but Michael Pento, senior economist with Euro Pacific Capital, has been making this case for years.

"It's not a surprise to me," Pento says of Standard & Poor's revision. "It's clearly late. But at least S&P is now waking up to the fact that the American sovereign debt picture is unsustainable and eventually we have to default on our debt in some form."

Just how late is S&P's revision to its outlook of U.S. debt?

"I heard that the ratings agencies just downgraded the Titanic's chances of crossing the Atlantic," Pento jokes.

Being late to the game is not a new criticism of credit ratings agencies like Standard & Poor's, Moody's and Fitch Ratings. They have been hammered for their role in the financial crisis, with critics arguing that the agencies were negligent for continuing to rate securities of subprime-related loans highly even as the market deteriorated. Once again, they are being lambasted for their inability to be forward looking.

In the report released Monday, S&P analysts write that there is a "material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013."

If an agreement is not reached and meaningful implementation is not begun by then, S&P analyst Nikola Swann writes, the U.S. fiscal profile would be rendered "meaningfully weaker than that of peer 'AAA' sovereigns."

"If nothing else, this puts a stamp on the problems in Washington with the budget disagreements and continued spending," says Paul Nolte, managing director with Chicago-based Dearborn Partners. "It's not healthy for the long term. A lot of people say that we'll just raise the debt limit like we have the last 39 times. This report puts the problems of continued big deficits front and center in front of everyone's faces."

If being late weren't maddening enough to critics, S&P's Swann offers an irritating 1-in-3 likelihood that the firm could lower the long-term rating on the U.S. within two years.

"I don't know how you handicap something as complex as the U.S. government," says Nolte. "Is it any easier to handicap Brazil or Greece? I don't necessarily agree with it."

But given S&P's outlook revision, Nolte understands it's all about the triple-A rating of the U.S. and how safe that rating is. "It's the first question out of everyone's mouth, when or if that will go away," he says. "You have to handicap it."

The timing of S&P's release of the report may be confusing, but investment managers argue it's easy to invest on the news. Following the release of the S&P's report, the 10-year U.S. Treasury dropped in price, pushing the yield closer to 3.5%. While he criticizes S&P for its lateness in the outlook revision, Pento says investors should not ignore the point the ratings agency is making.

"You get 3.5% over 10 years and you have Standard & Poor's telling you that your credit outlook is negative," Pento says. "What interest do you want to get paid on that? Wake up, America. Wake up, Chinese, Japanese and Europeans. You are not getting paid back in real terms the money you have lent us."

Investors were already concerned about rising rates before Monday's jolt, as the Federal Reserve is widely expected to end its second round of quantitative easing in June. The central bank has been the biggest buyer in the market, snatching up $600 billion in the liquidity program known as QE2.

Pento offers two areas where investors should turn in the wake of S&P's revision. "Despite the fact that some people think it's a bubble, investors should have significant exposure to precious metals and energy," he says. "That's your first line of defense against a currency that is being crumbled."

While the Dow Jones Industrial Average and S&P 500 dropped nearly 2% Monday, gold stocks like Newmont Mining ( NEM) and Royal Gold ( RGLD) were holding onto gains as gold rose to nearly $1,500 an ounce.

Andrew Fitzpatrick, director of investments with Chicago-based Hinsdale Associates, says investors should manage risk exposure by diversifying and cushion the shocks in the market. He argues that there are a lot of risks inherent to metals and commodities. "Despite being a hedge, it could suffer losses by correlating closer to the stock market," he says.

Instead, Fitzpatrick turns to market-leading dividend payers like Procter & Gamble ( PG) and Tyco International ( TYC) for downside protection and global exposure, and he looks to growth names like EMC ( EMC) and Apple ( AAPL) as tech names for upside opportunity.

Meanwhile, Nolte says the debt issue will develop over the next five to 10 years, and will have less of an impact over the short term. To capitalize on that, he is turning to stocks like Philip Morris ( PM), PepsiCo ( PEP) and Coca-Cola ( KO), which offer global exposure and healthy dividends.

Even with the opportunities investment managers see in the market currently, they all acknowledge how serious the S&P warning is for investors.

"This is a very serious situation," Pento adds. "We have a credit rating of the world's reserve currency taken to negative from stable. This is a dramatic, watershed moment in American history. It has epic ramifications for us and our children."

-- Written by Robert Holmes in Boston.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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