Sovereign Ratings, Default Risk and Markets: The Moody's Downgrade Aftermath!

 I was on a family vacation in August 2011 when I received an email from a journalist asking me what I thought about the S&P ratings downgrade for the US. Since I stay blissfully unaware of most news stories and things related to markets when I am on the beach, I had to look up what he was talking about, and it was S&P's decision to downgrade the United States, which had always enjoyed AAA, the highest sovereign rating  that can be granted to a country, to AA+, reflecting their concerns about both the fiscal challenges faced by the country, with mounting trade and budget deficits, as well as the willingness of its political institutions to flirt with the possibility of default. For more than a decade, S&P remained the outlier, but in 2023, Fitch joined it by also downgrading the US from AAA to AA+, citing the same reasons. That left Moody's, the third of the major sovereign ratings agencies, as the only one that persisted with a Aaa (Moody's equivalent of AAA) for the US, but that changed on May 16, 2025, when it too downgraded the US from Aaa (negative) to Aa1 (stable). Since the ratings downgrade happened after close of trading on a Friday, there was concern that markets would wake up on the following  Monday (May 19) to a wave of selling, and while that did not materialize, the rest of the week was a down week for both stocks and US treasury bonds, especially at the longest end of the maturity spectrum. Rather than rehash the arguments about US debt and political dysfunction, which I am sure that you had read elsewhere, I thought I would take this moment to talk about sovereign default risk, how ratings agencies rate sovereigns, the biases and errors in sovereign ratings and their predictive power, and use that discussion as a launching pad to talk about how the US ratings downgrade will affect equity and bond valuations not just in the US, but around the world.

Sovereign Defaults: A History

    Through time, governments have often been dependent on debt to finance themselves, some in the local currency and much in a foreign currency. A large proportion of sovereign defaults have occurred with foreign currency sovereign borrowing, as the borrowing country finds itself short of the foreign currency to meet its obligations. However, those defaults, and especially so in recent years, have been supplemented by countries that have chosen to default on local currency borrowings. I use the word "chosen" because most countries  have the capacity to avoid default on local currency debt, being able to print money in that currency to pay off debt, but chose not to do so, because they feared the consequences of the inflation that would follow more than the consequences of default.

BoC/BoE Sovereign Default Database

While the number of sovereign defaults has ebbed and flowed over time, there are two points worth making about the data. The first is that, over time, sovereign defaults, especially on foreign currency debt, have shifted from bank debt to sovereign bonds, with three times as many sovereign defaults on bonds than on bank loans in 2023. The second is that local currency defaults are persistent over time, and while less frequent than foreign currency defaults, remain a significant proportion of total defaults.

    The consequences of sovereign default have been both economic and political. Besides the obvious implication that lenders to that government lose some or a great deal of what is owed to them, there are other consequences. Researchers who have examined the aftermath of default have come to the following conclusions about the short-term and long-term effects of defaulting on debt:

1. Default has a negative impact on the economy, with real GDP dropping between 0.5% and 2%, but the bulk of the decline is in the first year after the default and seems to be short lived.
2. Default does affect a country’s long-term sovereign rating and borrowing costs. One study of credit ratings in 1995 found that the ratings for countries that had defaulted at least once since 1970 were one to two notches lower than otherwise similar countries that had not defaulted. In the same vein, defaulting countries have borrowing costs that are about 0.5 to 1% higher than countries that have not defaulted. Here again, though, the effects of default dissipate over time.
3. Sovereign default can cause trade retaliation. One study indicates a drop of 8% in bilateral trade after default, with the effects lasting for up to 15 years, and another one that uses industry level data finds that export-oriented industries are particularly hurt by sovereign default.
4. Sovereign default can make banking systems more fragile. A study of 149 countries between 1975 and 2000 indicates that the probability of a banking crisis is 14% in countries that have defaulted, an eleven percentage-point increase over non-defaulting countries.
5. Sovereign default also increases the likelihood of political change. While none of the studies focus on defaults per se, there are several that have examined the after-effects of sharp devaluations, which often accompany default. A study of devaluations between 1971 and 2003 finds a 45% increase in the probability of change in the top leader (prime minister or president) in the country and a 64% increase in the probability of change in the finance executive (minister of finance or head of central bank).

In summary, default is costly, and countries do not (and should not) take the possibility of default lightly. Default is particularly expensive when it leads to banking crises and currency devaluations; the former has a longstanding impact on the capacity of firms to fund their investments whereas the latter create political and institutional instability that lasts for long periods.

Sovereign Ratings: Measures and Process

    Since few of us have the resources or the time to dedicate to understanding small and unfamiliar countries, it is no surprise that third parties have stepped into the breach, with their assessments of sovereign default risk. Of these third-party assessors, bond ratings agencies came in with the biggest advantages:

1. They have been assessing default risk in corporations for a hundred years or more and presumably can transfer some of their skills to assessing sovereign risk.
2. Bond investors who are familiar with the ratings measures, from investing in corporate bonds, find it easy to extend their use to assessing sovereign bonds. Thus, a AAA rated country is viewed as close to riskless whereas a C rated country is very risky. 

Moody’s, Standard and Poor’s and Fitch’s have been rating corporate bond offerings since the early part of the twentieth century. Moody’s has been rating corporate bonds since 1919 and started rating government bonds in the 1920s, when that market was an active one. By 1929, Moody’s provided ratings for almost fifty central governments. With the Great Depression and the Second World War, investments in government bonds abated and with it, the interest in government bond ratings. In the 1970s, the business picked up again slowly. As recently as the early 1980s, only about thirteen  governments, mostly in developed and mature markets, had ratings, with most of them commanding the highest level (Aaa). The decade from 1985 to 1994 added 34 countries to the sovereign rating list, with many of them having speculative or lower ratings and by 2024, Moody's alone was rating 143 countries, covering 75% of all emerging market countries and almost every developed market. 

Not only have ratings agencies become more active in adding countries to their ratings list, but they have also expanded their coverage of countries with more default risk/ lower ratings.  In fact, the number of Aaa rated countries was the same in 1985, when there were thirteen rated countries, as in 2025, when there were 143 rated countries. In the last two decades, at least five sovereigns, including Japan, the UK, France and now the US, have lost their Aaa ratings.  In addition to more countries being rated, the ratings themselves have become richer. Moody’s and S&P now provide two ratings for each country – a local currency rating (for domestic currency debt/ bonds) and a foreign currency rating (for government borrowings in a foreign currency). 

    In assessing these sovereign ratings, ratings agencies draw on a multitude of data, quantitative and qualitative. Moody's describes its sovereign ratings process in the picture below:

The process is broad enough to cover both political and economic factors, while preserving wiggle room for the ratings agencies to make subjective judgments on default that can lead to different ratings for two countries with similar economic and political profiles. The heat map below provides the sovereign ratings, from Moody's, for all rated countries the start of 2025:

Moody's sovereign ratings

Note that the greyed out countries are unrated, with Russia being the most significant example; the ratings agencies withdrew their rating for Russia in 2022 and not reinstated it yet. There were only a handful of Aaa rated countries, concentrated in North America (United States and Canada), Northern Europe (Germany, Scandinavia), Australia & New Zealand and Singapore (the only Aaa-rated Asian country. In 2025, there have been a eight sovereign ratings changes, four upgrades and four downgrades, with the US downgrade from Aaa to Aa1 as the highest profile change

With the US downgrade, the list of Aaa-rated countries has become shorter, and as Canada and Germany struggle with budget imbalances, the likelihood is that more companies will drop off the list.

Sovereign Ratings:  Performance and Alternatives

    If sovereign ratings are designed to measure exposure to default risk, how well do they do? The answer depends on how you evaluate their performance. The ratings agencies provide tables that list defaults by rating that back the proposition that sovereign ratings and default are highly correlated. A Moody's update of default rates by sovereign ratings classes, between 1983 and 2024, yielded the following:

Default rates rise as sovereign ratings decline, with a default rate of 24% for  speculative grade sovereign debt (Baa2 and below) as opposed to 1.8% for investment grade (Aaa to Baa1) sovereign debt.

    That said, there are aspects of sovereign ratings that should give pause to anyone considering using them as their proxy for sovereign default, they do come with caveats and limitations:

1. Ratings are upward biased: Ratings agencies have been accused by some of being far too optimistic in their assessments of both corporate and sovereign ratings. While the conflict of interest of having issuers pay for the rating is offered as the rationale for the upward bias in corporate ratings, that argument does not hold up when it comes to sovereign ratings, since not only are the revenues small, relative to reputation loss, but a proportion of sovereigns are rated for no fees.
2. There is herd behavior: When one ratings agency lowers or raises a sovereign rating, other ratings agencies seem to follow suit. This herd behavior reduces the value of having three separate ratings agencies, since their assessments of sovereign risk are no longer independent.
3. Too little, too late: To price sovereign bonds (or set interest rates on sovereign loans), investors (banks) need assessments of default risk that are updated and timely. It has long been argued that ratings agencies take too long to change ratings, and that these changes happen too late to protect investors from a crisis.
4. Vicious Cycle: Once a market is in crisis, there is the perception that ratings agencies sometimes overreact and lower ratings too much, thus creating a feedback effect that makes the crisis worse. This is especially true for small countries that are mostly dependent on foreign capital for their funds.
5. Regional biases: There are many, especially in Asia and Latin America, that believe that the ratings agencies are too lax in assessing default risk for North America and Europe,  overrating countries in  those regions, while being too stringent in their assessments of default in Asia, Latin America and Africa, underrating countries in those regions. 

In sum, the evidence suggests that while sovereign ratings are good measures of country default risk, changes in ratings often lag changes on the ground, making them less useful to lenders and investors.

    If the key limitation of sovereign ratings is that they are not timely assessors of country default risk, that failure is alleviated by the development of the sovereign CDS market, a market where investors can buy insurance against country default risk by paying an (annualized) price. While that market still has issues in terms of counterparty risk and legal questions about what comprises default, it has expanded in the last two decades, and at the start of 2025, there were about 80 countries with sovereign CDS available on them. The heat map below provides a picture of sovereign (10-year)  CDS spreads on January 1, 2025:

As you can see, even at the start of 2025, the market was drawing a distinction between  the safest Aaa-rated countries (Scandinavia, Switzerland, Australia and New Zealand), all with sovereign CDS spreads of 0.20% or below, and more risky Aaa-rated countries (US, Germany, Canada). During 2025, the market shocks from tariff and trade wars have had an effect, with sovereign CDS spreads increasing, especially in April. The US, which started 2025 with a sovereign CDS spread of 0.41%, saw a widening of the spread to 0.62% in late April, before dropping back a bit in May, with the Moody's downgrade having almost no effect on the US sovereign CDS spread.

The US Downgrade: Lead-in and Aftermath

    With that background on sovereign default and ratings, let's take a look at the story of the moment, which is the Moody's downgrade of the US from Aaa to Aa1. In the weeks since, we have not seen a major upheaval in markets, and the question that we face as investors and analysts is whether anything of consequence has changed as a result of the downgrade.

The Lead-in

    As I noted at the start of this post, Moody's was the last of the big three sovereign ratings agencies giving the United States a Aaa rating, with S&P (in 2011) and Fitch (in 2023) having already downgraded the US. In fact, the two reasons that both ratings agencies provided at the time of their downgrades were rising government debt and politically dysfunction were also the reasons that Moody's noted in their downgrade. On the debt front, one of the measures that ratings agencies use to assess a country's financial standing is its debt to GDP ratio, and it is undeniable that this statistic has trended upwards for the United States:

The ramping up of US debt since 2008 is reflected in total federal debt rising from 80% of GDP in 2008  to more than 120% in 2024. While some of the surge in debt can be attributed to the exigencies caused by crises (the 2008 banking crisis and the 2020 COVID bailouts), the troubling truth is that the debt has outlasted the crises and blaming the crises for the debt levels today is disingenuous. 

    The problem with the debt-to-GDP measure of sovereign fiscal standing is that it is an imperfect indicator, as can be seen in this list of countries that scored highest and lowest on this measure in 2023:

IMF

Many of the countries with the highest debt to GDP ratios would be classified as safe and some have Aaa ratings, whereas very few of the countries on the lowest debt to GDP list would qualify as safe. Even if it it the high debt to GDP ratio for the US that triggered the Moody's downgrade, the question is why Moody's chose to do this in 2025 rather than a year or two or even a decade ago, and the answer to that lies, I think, in the political component. A sovereign default has both economic and political roots, since a government that is intent on preserving its credit standing will often find ways to pay its debt and avoid default. For decades now, the US has enjoyed special status with markets and institutions (like ratings agencies), built as much on its institutional stability (legal and regulatory) as it was on its economic power. The Moody's downgrade seems to me a signal that those days might be winding down, and that the United States, like the rest of the world, will face more accountability for lack of discipline in its fiscal and monetary policy.

Market Reaction

    The ratings downgrade was after close of trading on Friday, May 16, and there was concern about how it would play out in markets, when they opened on Monday, May 19. US equities were actually up on that day, though they lost ground in the subsequent days:

If equity markets were relatively unscathed in the two weeks after the downgrade, what about bond markets, and specially, the US treasury market? After all, an issuer downgrade for any bond is bad news, and rates should be expected to rise to reflect higher default risk:

While rates did go up in the the first few days after the downgrade, the effect was muddled by the passage of a reconciliation bill in the house that potentially could add to the deficit in future years. In fact, by the May 29, 2025, almost all of the downgrade effect had faded, with rates close to where they were at the start of the year.

    You may be surprised that markets did not react more negatively to the ratings downgrade, but I am not for three reasons:

1. Lack of surprise effect: While the timing of the Moody's downgrade was unexpected, the downgrade itself was not surprising for two reasons. First, since S&P and Fitch had already downgraded the US, Moody's was the outlier in giving the US a Aaa rating, and it was only a matter of time before it joined the other two agencies. Second, in addition to reporting a sovereign rating, Moody's discloses when it puts a country on a watch for a ratings changes, with positive (negative) indicating the possibility of a ratings upgrade (downgrade). Moody's changed its outlook for the US to negative in November 2023, and while the rating remained unchanged until May 2025, it was clearly considering the downgrade in the months leading up to it.
2. Magnitude of private capital: The immediate effect of a sovereign ratings downgrade is on government borrowing, and while the US does borrow vast amounts, private capital (in the form of equity and debt) is a far bigger source of financing and funding for the economy. 
3. Ratings change: The ratings downgrade ws more of a blow to pride than to finances, since the default risk (and default spread) difference between an Aaa rating and a Aa1 rating is small. Austria and Finland, for instance, had Aa1 ratings in May 2025, and their ten-year bonds, denominated in Euros, traded at a spread of about 0.15- 0.20% over the German ten-year Euro bond; Germany had a Aaa rating.

Consequences for valuation and investment analysis

   While the immediate economic and financial consequences of a downgrade from Aaa to Aa1 will be small, there are implications for analysts around the world. In particular, analysts will have to take steps when working with US dollars that they may already be taking already when working with most other currencies in estimating basic inputs into financial analysis.

    Let's start with the riskfree rate, a basic building block for estimating costs of equity and capital, which are inputs into intrinsic valuation. In principle, the riskfree rate is what you will earn on a guaranteed investment in a currency, and any risk premiums, either for investing in equity (equity risk premium) or in fixed income securities (default spreads), are added to the riskfree rate. It is standard practice in many textbooks and classrooms to use the government bond rate as the risk free rate, but that is built on the presumption that governments cannot default (at least on bonds issued in the local currency). Using a Aaa (AAA) rating as a (lazy) proxy for default-free, that is the rationale we used to justify government bond rates as riskfree rates at the start of 2025, in Australian, Singapore and Canadian dollars, the Euro (Germany). Swiss francs and Danish krone. As we noted in the first section, the assumption that governments don't default  is violated in practice, since some countries choose to default on local currency bonds, rather than face up to inflation. If that is the case, the government bond rate is no longer truly a riskfree rate, and getting to a riskfree rate will require netting out a default spread from the government bond rate:

Risk free rate = Government Bond rate − Default spread for the government 

The default spread can be estimated either from the sovereign bond rating (with a look up table) or a sovereign CDS spread, and we used that process to get riskfree in rates in a  host of currencies, where local currency government bonds had default risk, at the start of 2025:

Thus, to get a riskfree rate in Indian rupees, Brazilian reals or Turkish lira, we start with government bonds in these currencies and net out the default spreads for the countries in question. We do this to ensure that we don't double count country risk by first using the government bond (which includes default risk) as a riskfree rate and then using a larger equity risk premium to allow for the same country risk.  

    Now that the US is no longer Aaa rated, we have to follow a similar process to get a riskfree rate in US dollars:

• US 10-year treasury bond rate on May 30, 2025  = 4.41%
• Default spread based on Aa1 rating on May 30, 2025  = 0.40%
• Riskfree rate in US dollars on May 30, 2025 = US 10-year treasury rate - Aa1 default spread = 4.41% - 0.40% = 4.01%

This adjustment yields a riskfree rate of 4.01% in US dollars, and it is also built on the presumption that the default spread manifested after the Moody's downgrade on May 16, when the more realistic reading is that US treasury markets have been carrying a  default spread embedded in them for years, and that we are not making it explicit.

    The ratings downgrade for the US will also affect the equity risk premium computations that I use to estimate the cost of equity for companies. As some of you who track my equity risk premiums by country know, I estimate an equity risk premium for the S&P 500, and at least until the start of this year, I used that as a premium for all mature markets (with a AAA (Aaa) rating as the indicator of maturity). Thus, countries like Canada, Germany, Australia and Singapore were all assigned the same premium as that attributed to the S&P 500. For countries with ratings below Aaa, I added an "extra country risk premium"  computed based upon the default spreads that went with the country ratings:

With the ratings downgrade, I will have to modify this process in three ways. The first is that when computing the equity risk premium for the S& P 500, I will have to net out the adjusted riskfree rate in US dollars rather than the US treasury rate, yielding a higher equity risk premium for the US. Second, for Aaa rated countries, to the extent that they are safer than the US will have to be assigned an equity risk premium lower than the US, with the adjustment downward reflecting the Aa1 rating for the US. The third is that for all other countries, the country risk premium will be computed based upon the the their default spreads and the equity risk premium estimated for Aaa rated countries (rather than the US equity risk premium):

How will the cost of equity for a firm with all of its revenues in the United States be affected as a consequence? Let's take three companies, one below-average risk, one average-risk and one above average risk, and compute their costs of equity on May 30, 2025, with and without the downgrade factored in:

As you can see, the expected return on the S&P 500 as of May 30, 2025, reflecting the index level then and the expected cash flows, is 8.64%. Incorporating the effects of the downgrade changes the composition of that expected return, resulting in a lower riskfree rate (4.01% instead of 4.41%) and a higher equity risk premium (4.63% instead of 4.23%). Thus, while the expected return for the average stock remains at 8.64%, the expected return increases slightly for riskier stocks and decreases slightly for safer stocks, but the effects are so small that investors will hardly notice. If there is a lesson for analysts here, it is that the downgrade's effects on the discount rates (costs of equity and capital) are minimal, and that staying with the conventional approach (of using the ten-year US treasury bond rate as the riskfree rate and using that rate to compute the equity risk premium) will continue to work.

Conclusion

    The Moody's ratings downgrade of the US made the news, and much was made of it during the weekend that followed. The financial and economic consequences, at least so far, have been inconsequential, with equity and bond markets shrugging off the downgrade, perhaps because the surprise factor was minimal. The downgrade also has had only a minimal impact on costs of equity and capital for US companies, and while that may change, the changes will come from macroeconomic news or from crises. For the most part, analysts should be able to continue to work with the US treasury rate as a riskfree rate and forward-looking equity risk premiums, as they did before the downgrade. With all of that said, though, the Moody's action does carry symbolic weight, another indicator that US exceptionalism, which allowed the US to take economic and fiscal actions that would have brought blowback for other countries, especially in emerging markets, is coming to an end. That is healthy, in the long term, for both the United States and the rest of the world, but it will come with short term pain.

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The Greed & Fear Tango: The Markets in April 2025!

    I started the month on a trip to Latin America, just as the tariff story hit my newsfeed and the market reacted with a sell off that knocked more than $9 trillion in market cap for global equities in the next two days. The month was off to a bad start, and tariffs remained the lead story for much of the month, contributing to both its biggest down days (with stories of trade war escalation) and to the biggest up days (with news of relief from the fight). To add to the volatility, there was talk midway through the month of replacing Jerome Powell as the Fed Chair, and assorted news adding to uncertainty about the direction of the economy. An observer reading just the news stories and asked to guess what the market did during the month would probably have bet on stocks falling steeply, but he or she would have lost that bet, because markets managed to surprise us all again, ending the month almost where they began.

Equities: Storm Clouds gather (and dissipate)!

    It would be an understatement to describe equity markets in April 2025 as volatile, with the equity indices going through stomach wrenching up and down movements intraday and across days, as investors struggled to price in a world of tariffs, trade wars and policy uncertainty.

The journey that the indices went through during the course of the month has been extraordinary. Each of the indices lost close to 10%  in the first two days of the month, went deeper into the hole in the second week of the month, but by the end of the month, they had each found their way back to almost where they started the month at, with the S&P 500, NASDAQ and the MSCI world index all within 1% of their start-of-the-month levels.

    As I noted in my post right after the first couple of days of this month, where I framed the market crisis around tariffs, the indices sometimes obscure markets shifts that are occurring under the surface, and that looking at all publicly traded stocks on an aggregated basis provides a more complete picture. I will start by looking at the regional breakdown of what the month delivered in terms of change in market cap, in both dollar and percentage terms:

The crisis may have been birthed in the United States, but as has been the case with market crises in this century, it has spread across the world, with disparate impacts. There are truly no standouts in either direction, with China being the worst performing region, in terms of percentage change in dollar value, down 3.69%, and India and Latin America tied for best performing, up 3.57%.  These are dollar returns, and since the US dollar came under selling pressure during the course of the month, the local currency returns were worse, especially in markets, like the EU, where the Euro gained about 5% in the courser of the month.

    At the start of the month, as has been the case for much of the last decade, the focus was on technology, partly because of its large weight in overall equity value at the start of 2025, and partly because of the punishment meted out to tech stocks during the first quarter of the year.  Focusing just on US equities, technology companies, which accounted for 29.4% of the overall market capitalization of all US companies at the start of 2025, lost $2.34 trillion (about 13.19%) in market capitalization in the first quarter of 2025. In the first few days of April, that trend continued as technology initially led the rout, losing an additional $1.78 trillion, but by the end of April, tech had made at least a partial comeback:

As you can see, technology ended the month as the second best performing sector, up 1.67% for the month, and in spite of the handwringing about their poor performance, their share of the market cap pie has barely changed after the first four months of 2025. While the first quarter continues to weigh the sector down, as was the case in 2022, the obituaries written for technology investing may have been premature.

    Staying in the weeds, I also looked at the push and pull of growth versus value, by breaking US equities down into deciles based on earnings to price ratios and assessing their performance leading into April and in April 2025 alone:

As you can see, while there is no clearly discernible pattern across deciles of US stocks based upon earnings to price ratios, breaking down US stocks into a top and bottom half, based upon the ratio, yields the conclusion that while high PE stocks had a bad start to the year, losing 10.9% of their value in the first quarter, they made a comeback in April, up 1.74% for the year,  while low PE stocks were down 2.22% for the month. That pattern of a reversal in April 2025 of trends that had been forming in the first quarter of 2025 shows upon in other proxies for the value versus growth tussle:

• Looking at companies broken down by market capitalization into deciles, you find that larger cap companies outperformed small cap stocks during April, 
• Breaking down stocks based on dividends, dividend paying stocks and companies buying back stock underperformed non-cash returning stocks, indicating that there was no flight to safety in April.

    Finally, I classified companies based upon their stock price performance in 2024 to see if what we are seeing in 2025 is just a correction of overreach in 2024. After all, if that is the case, we should see the stocks that have performed the best in 2024 be the ones that have taken the most punishment this year:

As you can see, momentum returned in force in April, with the best performing stocks in 2024 up 0.76% during the month, while the worst performing stocks of 2024 were down 5.31% for the month. In fact, the year-to-date numbers for 2025 indicate that momentum remains in the driver's seat, extending a long period of outperformance. 

    In sum, the market stresses in April 2025 seems to have pushed the market back into its 2024 ways, after a first quarter that promised reversal, as technology, growth and momentum all made a comeback in the last three weeks of April. The performance of the Mag Seven, which represent a combination of all three forces (large, high growth and technology), in April provides a tangible measure of this shift:

The Mag Seven have had a bad year to date, losing $2.6 trillion in market capitalization, but they made a comeback from the depths to finish April at about the same market cap that they had at the start of the month, recovering almost all of the $1.55 trillion that they lost in the first week of the month.

    In short, not only did equities recover in the last three weeks of April 2025, but there seems have been a shift in sentiment back the forces that have borne markets upwards for the last few years, with technology, growth and momentum returning as market drivers. Of course, three weeks is a short time, but this is a trend worth watching for the rest of this year.

The Rest of the Market: Swirling Winds?

    As equities careened through April 2025 between panic and delirium, the other asset classes were surprisingly staid, at least on the surface, starting with the US treasuries. Unlike other crises, where US treasuries saws funds flow in, pushing down yields and pushing up prices, treasury rates remained relatively stable through much of April:

Not only did rates remain almost unchanged across the maturity spectrum, but they were stable on a week-to-week basis. The yield curve, downward sloping for much of the last two years,  is now u-shaped, with 3-month rates and 2-year rates higher than 5-year rates, before reverting back to higher longer term (10-year and 30-year rates). Coming from the camp that we read too much economic significance into yield curve slopes and dynamics, I am reluctant to draw big conclusions, but some of this can be attributed to expectations of higher inflation in the near term. There is another force at play in this crisis that has not been as visible in past ones, at least in the US treasury market, and that is concerns about the trustworthiness of the US government Though this is still an early indicator, that can be seen in the sovereign CDS market, where investors pay for insurance against default risk, and where the US CDS spread has risen in April:

The sovereign CDS spread for the US has risen about 38% during the course of this month, and the interesting part is that much of that rise happened in the last three weeks of the month, and during the first week, when equities were collapsing. The rise in perceptions of US default risk is more likely to have been precipitated by the threat to fire Jerome Powell, and by extension to the independence of the Fed as an institution. While that threat was withdrawn, the sovereign CDS spread has stayed high, and it will be worth watching whether it will come back down or whether some permanent damage has been done to US treasuries as a safe haven. As some of you who follow my thinking on riskfree rates may know, I argue that the riskfree rate in a currency is not necessarily the government bond rate in that currency, and that the default spread has to netted out from the government bond rate two get to a riskfree rate, if the sovereign in question is not viewed as default-free. Building on that principle, I may soon have to revisit my practice of using the US treasury rate as the riskfree rate in US dollars and net out a default spread for the US from that rate to get to a riskfree rate.

    During April 2025, commodity prices were also on the move, and in the graph below, I look at oil prices as well as an overall commodity index during the month: 

In the first third of the month, oil prices, in particular, and commodity prices, in general, joined equities, as they moved down, but in the last part of the month, they delinked, and stayed down, even as stock prices bounced back up. To the extent that the demand for commodities is driven by real economic growth, that would suggest that at least in the near term, the tariffs that precipitated the crisis will slow down global economies and reduce demand for commodities. 

    The concerns about central banking independence that triggered the surge in the US sovereign CDS spread also played out in currency markets, where the US dollar, already weakened in the first quarter, continued its decline in April. In the graph below, I look at the dollar-euro exchange rate and an index measuring the strength of the dollar against multiples currencies.

The dollar continued its decline in April, down about 3% against a broad basket of currencies, and more than 5% against the Euro. 

    Finally, I looked at two other investment classes - gold and bitcoin - for the same reasons that I brought them into the discussion at the start of April. They are collectibles, i.e., investments that investors are drawn to during crisis periods or when they lose faith in paper currencies and governments:

Download data

Gold had a good month in April, up about 5.3%, and hitting $3.500 towards the end of the month, but Bitcoin did even better rising almost 14.12% during the course of the month. That said, the fact that financial asset markets (equity and bond) recovered over the second part of the month made this a month where collectibles were not put to their test as crisis investments, and the rise in both can be attributed more to the loss of trust that has driven  the sovereign CDS spread up and the US dollar down.

Risk and Co-movement

    Early in April, I argued that the one number that would track the balance between greed and fear in markets would be the price of risk in markets, and I resolved to estimate that price every day, through April, for both equity and bond markets. With equity markets, the price of risk is the equity risk premium, and at least  in my estimation process, it is a forward-looking number determined by the level of stock prices and expected cash flows. In the table below, I report on my estimates of the equity risk premium for the S&P 500 every trading day in April, in conjunction with the VIX, and equity volatility index that should be correlated:

Download day-to-day data

After rising above 5% in the first third of the month, the equity risk premium decreased in fits and starts over the rest of the month to end at almost the same value (4.58%) as at the start of the month (4.59%). In parallel, the VIX soared in the first few days of the month to peak at 52.33 on April 8, and then decreased over the rest of the month to a level (24.70) close to where it was at the start of the month (22.28).

    In the bond market, the price of risk takes the form of default spreads, and these spreads followed a similar path to the equity risk measures:

Download data

The default spread on high yield bonds surged, rising by more than 1% between the start of the month and April 7, before declining, but unlike the equity risk measures, the bond default spreads did end the month at levels higher than at the start, indicating at least at this point that near term concerns about the economy and the ensuing default risk have not subsided.

    As a final exercise, I looked at the correlation in price changes across investment classes - stocks, treasuries, investment-grade and high-yield corporate bonds, commodities, gold and bitcoin:

Download data

With the caveat that this is just 22 trading days in one month, it does yield some preliminary results about co-movements. First, stock and treasury bond prices moved together much of the month, not something that you would expect during a crisis, when bond prices gain as stock prices fall. Second, while both gold and bitcoin prices moved with stocks, gold prices movements were more closely tied to stock price movements, at least during the month. In sum, the movement across asset markets affirms our conclusion from looking at company-level data that this was more a month of asset reprising than panic selling or buying.

    In sum, if I were to summarize what the data is pointing me towards, here are the general conclusions that I would draw, albeit with a small sample:

1. The market movements through much of the month were less driven by panic and more by investors trying to reprice companies to reflect a world with more trade barriers and tariffs and political turmoil.
2. While equities, in the aggregate, ended the month roughly where they started the month, a shift in sentiment seemed to occur in the last three weeks of the month, as technology, growth and momentum, three forces that seemed to be in retreat in the first quarter of 2025, made a come back.
3. With US treasuries, there was little movement on the rates, but under the surface, there were shifts  that could be tectonic in the long term. There was clearly a drop in trust in the US government and its institutions, which played out in rising sovereign CDS spreads and a declining dollar, and trust once lost can be difficult to gain back.
4. The investment classes that are most vulnerable to the real economy, i.e.. commodities and higher yield corporate bonds, were down for the month, indicating a slowing down of global economic growth.

In the coming months, we will see whether the last three weeks of April were an aberration or the start of something bigger.

Lessons Learned

    Every market meltdown carries pain to investors, but that pain is often spread unevenly across these investors, with the variation driven as much as by what they held coming into the crisis, as it is by how they behaved in response to the sell off. I am not sure April 2025 falls into the crisis column, but it did feel like one early in the month, and as I look back at the month, I come back to three market characteristics that stood out.

1. Market resilience: In the last five years, markets have repeatedly not only got the big trends right, but they have also shown far more resilience than any expert group. I would wager that if you had given a group of macro economists or market strategists just the news stories that came out during the course of the month and asked them to guess how they would play out in market reaction, almost none of them would have guessed the actual outcome (of flat markets). At the time of COVID, I argued that one reason for market resilience is that market influence has become diffuse, with social media and alternative sources of information supplementing and often replacing the traditional influencers - the financial press, media and investment talking heads, and market movements are less driven by large portfolio managers exhibiting herd behavior and more by disparate groups of traders, with different motives, models and patterns. 
2. Market power: A key reason for the turnaround in markets during April was the administration's decision to walk back, reverse or delay actions that the market reacted to strongly and negatively. The "liberation day" tariffs that triggered the initial sell off have largely been put on hold or suspended, and the talk about replacing the Fed Chair was walked back quickly the week after it was made. In short, an administration that has been impervious to Wall Street journal editorials, warnings from economists and counter threats from other governments has been willing to bend to market selling pressure.
3. Market unpredictability: As markets rose and fell during the course of the month, the debate about the value added by active investing kicked into full gear. I heard quite a few advocates of active investing argue that it was during times like this (volatility and crisis) that the "sage counsel" and "timely decisions" of wealth or fund managers would protect investors on the downside. I would suggest the opposite, and am willing to bet that the extent of damage that April did to investor portfolios was directly proportional to how much time they spent watching CNBC and listening to (or reading) what market experts told them to do.

On a personal note, I stuck to my resolution early in the crisis to use it to stay true to my investment philosophy. As someone who stinks at market timing, I made no attempt to buy and sell the market through the month, perhaps leaving a great deal of money on the table, or more likely, saving myself just as much from getting the timing wrong. In the middle of April, I talked about three strands of  contrarian investing, and in that post, I put myself  in the opportunistic contrarian camp. I did use the mid-month sell off to add BYD, a stock that I like, to my portfolio, when its price dipped below my limit price ($80). Palantir and Mercado Libre (my two other limit buys) came close but not low enough to break through my limits, but I am willing to wait, revisiting my valuations along the way.

    I do have some portfolio maintenance work that I need to do in the coming weeks, especially on the six of the seven Mag Seven stocks that remain in my portfolio (Tesla is out of my portfolio and Nvidia is at a quarter of my original holding). As these companies report their first quarter earnings, I plan to revisit my valuations from last year, when in the face of mild to moderate over valuation, I chose to maintain my holdings. As in prior years, I will post my assessments of value and my hold/sell judgments, but that has to wait because I do have more immediate priorities. First, as a teacher, with the semester end approaching, I have a stack of grading that has to get done. Second, as a father, I am looking forward to my daughter having her first child next week, and the market and my portfolio take a distant second place to getting acquainted with my new granddaughter.

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My Posts (from April 2025)

1. Anatomy of a Market Crisis: Tariffs, Markets and the Economy!
2. Buy the Dip: The Draws and Dangers of Contrarian Investing

Data Links

1. Day-to-day numbers (ERP, default spreads and asset prices)

Buy the Dip: The Draw and Dangers of Contrarian Investing!

     When markets are in free fall, there is a great deal of  advice that is meted out to investors, and one is to just buy the dip, i.e., buy beaten down stocks, in the hope that they will recover, or the entire market, if it is down.  "Buying the dip" falls into a broad group of investment strategies that can be classified as "contrarian", where investors act in contrast to what the rest of the market is doing at the time, buying (selling) when the vast majority are selling (buying) , and it has been around through all of market history. There are strands of research in both behavioral finance and empirical studies that back up contrarian strategies, but as with everything to do with investing, it comes with caveats and constraints. In this post, I will posit that contrarian investing can take different forms, each based on different assumptions about market behavior, and present the evidence that we have on the successes and failures of each one. I will argue that even if you are swayed intellectually by the arguments for going against the crowd, it may not work for you, if you are not psychologically attuned to the stresses and demands that contrarian strategies bring with them.

Contrarianism - The Different Strands

    All contrarian investing is built around a common theme of buying an investment, when its price goes down significantly, but there are wide variations in how it is practiced. In the first, knee-jerk contrarianism, you use a bludgeon, buying either individual companies or the entire market when they are down, on the expectation that you will benefit from an inevitable recovery in prices. In the second, technical contrarianism, you buy beaten-up stocks or the entire market, but only if charting or technical indicators support the decision.  In the third, constrained contrarianism, you buy the stocks that are down, but only if they pass your screens for qualify and safety. In the fourth, opportunistic contrarianism, you use a price markdown as an opportunity to buy companies that you have always wanted to hold, but had not been able to buy because they were priced too high.

1. Knee-jerk Contrarianism

    The simplest and most direct version of contrarian investing is to buy any traded asset where the price is down substantially from its highs, with the asset sometimes being an individual company, sometimes a sector and sometimes the entire market. Implicit in this strategy is an absolute belief in mean reversion, i.e.,  that what goes down will almost always go back up, and that buying at the beaten down price and being willing to wait will therefore pay off.

    The evidence for this strategy comes from many sources. For the market, it is often built on papers (or books) that look at the historical data on what equity markets have delivered as returns over long periods, relative to what you would have made investing elsewhere. Using data for the United States, a  market with the longest and most reliable historical records, you can see the substantial payoff to investing in equities:

Download historical data

No matter what time period you use for your time horizon, stocks deliver the highest returns, of all asset classes, and there some who look at this record and conclude that "stocks always win in the long term", with the implication that you should stay fully invested in stocks, even through the worst downturns, if you have a reasonably long time horizon. These returns to buying stocks become greater, when you buy them when they are cheaper, measured either through pricing metrics (low PE ratios) or after corrections. There are two problems with the conclusion. The first is that there is selection bias, where using historical data from the United States, one of the most successful equity markets of the last century, to draw general conclusions about the risk and returns of investing in equities will lead you to underestimate equity risk and overestimate equity returns. The second is that, even with US equities, an investor who bought stocks just before a major downturn would have to wait a long time before being made whole again. Thus, investors who put their money in stocks in 1929, just ahead of the Great Depression, would not have recovered until 1954. 

    With individual stocks, the strongest backing for buying the dip comes from studies of "loser" stocks, i.e., stocks that have gone down the most over a prior period. In a widely cited paper from 1985, DeBondt and Thaler classified stocks based upon stock price performance in the prior three years into winner and loser portfolios, with the top fifty performers going into the "winner" portfolio, and the bottom fifty into the "losers portfolio", and estimated the returns you could have made on each group in the following thirty six months:

DeBondt and Thaler (1985)

As you can see, the loser portfolio dramatically outperforms the winner portfolio, delivering about 30% more on a cumulative basis than the winner portfolio in the thirty six months after the portfolios are created, which DeBondt and Thaler argued was evidence that markets overreact. About a decade later, Jegadeesh and Titman revisited the study, with more granular data on time horizons, and found that the results were reversed, if you shorten the holding period, with winner stocks continuing to win over the first year after portfolio creation. 

Jegadeesh and Titman (1993)

The reversal eventually kicks in after a year, but over the entire time period, the winner portfolio still outperforms the loser portfolio, on a cumulative basis. Jegadeesh and Titman also noted a skew in the loser portfolio towards smaller market cap and lower-priced stocks, with higher transactions costs (from bid-ask spreads and price impact). As other studies have added to the mix, the consensus on winner versus loser stocks is that there is no consensus, with evidence for both momentum, with winner stocks continuing to win, and for reversal, with loser stocks outperforming, depending on time horizon, and questions about whether these excess returns are large enough to cover the transactions costs involved.

    Setting aside the mixed evidence for the moment, the biggest danger in knee-jerk contrarian investing at the market level is that buying the dip in the market is akin to catching a falling knife, since that initial market drop can be a prelude to a much larger sell off, and to the extent that there was an economic or fundamental reason for the sell off (a banking crisis, a severe recession), there may be no near term bounceback. With individual stocks, that danger gets multiplied, with investors buying stocks that are being sold off to for legitimate reasons (a broken business model, dysfunctional management, financial distress) and waiting for a market correction that never comes. 

    To examine the kinds of companies that you would invest in, with a knee-jerk contrarian investing strategy , I looked at all US stocks with a market capitalization exceeding a billion dollars on December 31, 2024, and found the companies that were the biggest losers, on a percent basis, between March 28 and April 18 of 2025:

You will note that technology and biotechnology firms are disproportionately represented on the list, but that is the by-product of a bludgeon approach.

2. Technical Contrarianism

    In technical contrarianism, you start with the same basis as knee-jerk contrarianism, by  looking at stocks and markets that have dropped significantly, but with an added requirement that the price has to meet a charting or technical indicator constraint before becoming a buy. While there are many who consign technical analysis to voodoo investing, I believe that charting patterns and technical indicators can provide signals of shifts in mood and momentum that drive price movements, at least in the near term. Thus, you can view technical contrarianism as buying stocks or markets when they are down, but only if the charts and technical indicators point to a shift in market mood.

    One of the problems with testing technical contrarianism, to see if it works, is that even among technical analysts, there seems to be no consensus as to the best indicator to use, but broadly speaking, these indicators can be based on either price and/or volume movements. They range in sophistication from simple measures like relative strength (where you look at percentage price changes over a period) and moving averages to complex ones that combine price and volume. In recent decades, investors have added pricing in other markets to the mix, with the VIX (a traded volatility index) as well as the relative pricing of puts and calls in the options market being used in market timing. In sum, all of these indicators are directed at measuring fear in the market, with a "market capitulation" viewed as a sign that the market has bottomed out. 

    With market timing indicators, there is research backing up the use of VIX and trading volume as predictors of market movements, though with substantial error.

Source: S&P

As the VIX rises, the expected return on stocks in future periods goes up, albeit with much higher volatility around these expected returns. It is ironic that some of the best defenses of technical analysis have been offered by academics, especially in their studies of price momentum and reversal. Lo, Wang, and Mamaysky present a fairly convincing defense of technical analysis from the perspective of financial economists. They use daily returns of stocks on the New York Stock Exchange and NASDAQ from 1962 and 1996 and employ sophisticated computational techniques (rather than human visualization) to look for pricing patterns. They find that the most common patterns in stocks are double tops and bottoms, followed by the widely used head and shoulders pattern. In other words, they find evidence that some of the most common patterns used by technical analysts exist in prices. Lest this be cause for too much celebration among chartists, they also point out that these patterns offer only marginal incremental returns (an academic code word for really small) and offer the caveat that these returns may not survive transaction costs.

3. Constrained Contrarianism

    If you are in the old-time value investing camp, your approach to contrarian investing will reflect that worldview, where you will buy stocks that have dropped in value, but only if they meet the other criteria that you have for good companies. In short, you will start with a list of beaten up stocks, and then screen them for high profitability, strong moats and low risk, hoping to separate companies that are cheap from those that deserve to be cheap.

    As a constrained contrarian, you are hoping to avoid value traps, every value investor's nightmare , where a company looks cheap on a pricing basis (low PE, low price to book) and proceeds to become even cheaper after you buy it. The evidence on whether screening helps avoid value traps comes largely from studies of the interplay between proxies of value (such as low price to book ratios) and proxies for quality, including measures for both operating/capital efficiency (margins and returns on capital) and low risk (low debt ratios and volatility). Proponents of quality screens note that while value proxies alone no longer seem to deliver excess returns, incorporating quality screens seems to preserve these excess returns.  Research Affiliates, an investment advisory service, looked at returns to pure value screens versus value plus quality screens and presents the following evidence on how screening for quality improves returns:

Research Affiliates Study

The evidence is supportive of the hypothesis that adding quality screens improves returns, and does so more for stocks that look cheap (low price to book) than for expensive stocks. That said, the evidence is underwhelming in terms of payoff, at least on an annual return basis, though the payoff is greater, if you factor in volatility and estimate Sharpe ratios (scaling annual return to volatility).

    While much of the research on quality has been built around value and small cap investing, the findings can be extrapolated to contrarian investing, with the lesson being that rather than buy the biggest losers, you should be buying the losers that pass screening tests for high profitability (high returns on equity or capital) and low risk (low debt ratios and volatility). That may provide a modicum of protection, but the problem with these screens is that they are based upon historical data and do not capture structural changes in the economy or disruption in the industry, both of which have not yet found their way into the fundamentals that are in your screens.

    To provide just an illustration of constrained contrarianism, I again returned to the universe of about 6,000 publicly traded US stocks on April 18, 2025, and after removing firms with market capitalizations less than $100 million (with the rationale that these companies will have more liquidity risk and transactions costs), I screened first for stocks that lost more than 20% of their market capitalization between March 28 and April 18, and then added three value screens:

1. A PE ratio less than 15, putting the stock in the bottom quintile of US stocks as of December 31, 2024
2. A dividend yield that exceeded 1%, a paltry number by historical norms, but ensuring that the company was dividend-paying in 2024, a year in which 60% of US stocks paid no dividends
3. A net debt/EBITDA ratio of less than two, dropping it into the bottom quintile of US companies in terms of debt load

The six companies that made it through the screens are below:

I am sure that if you are a value investor, you will disagree about both the screens that I used as well as my cut offs, but you are welcome to experiment with your own screens to find bargains.

4. Opportunistic Contrarianism

    In a fourth variant of contrarian investing, you use a market meltdown as an opportunity to buy companies that you have always wanted to own but could not because they were over priced before the price drop, but look under priced after.  The best place to start an assessment of opportunistic investing is with my post on why good companies are not always good investments, with the first being determined by all of the considerations that go into separating great businesses from bad businesses, including growth and profitability, and the second by the price you have to pay to buy them. In that post, I had a picture drawing the contrast between good companies and good investments:

Put simply, most great companies are neutral or even bad investments, because the market prices them to be great. A year ago, when I valued the Mag Seven stocks, I argued that these were, for the most part, great businesses, with a combination of growth at scale, high profitability and deep moats, but that at the prices that they were trading  they were not great investments. 

I also argued that even great companies have their market travails, where for periods of time, investors lose faith in them and drive their prices down not just to value, but below. It happened to Microsoft in 2014, Apple in 2017, Nvidia in 2018, Tesla at multiple times in the last decade, and to Facebook, at the height of the Metaverse fiasco. While those corrections were caused by company-specific news stories and issues, the same process can play out, when you have significant market markdowns, as we have had over the last few weeks. 

    The process of opportunistic contrarianism starts well before a market correction, with the identification of companies that you believe are good or great businesses:

At the time that you first value them, you are likely to find them to be over valued, which will undoubtedly be frustration. You may be tempted to play with the numbers to make these companies look undervalued, but a better path is to put them  on your list of companies you would like to own, and leave them there. During a market crisis, and especially when investors are marking down the prices of everything, without discriminating between good and bad companies, you should revisit that list, with a caveat that you cannot compare the post-correction price to your pre-crisis valuation of your company. Instead, you will have to revalue the company, with adjustments to expected cash flows and risk premiums, given the crisis, and if that value exceeds the price, you should buy the stock. 

Contrarian Investing: The Psychological Tests!

    In the abstract, it is easy to understand the appeal of contrarian investing. Both behavioral and empirical research identify the existence of herd behavior in crowds, and point to tipping points where crowd wisdom becomes crowd madness. A rational decision-maker in the midst of animal spirits may feel that he or she has an advantage in this setting, and rightly so. That said, buying when the rest of the market is selling takes a mindset, a time horizon and a stronger stomach than most of us do not have.

1. The Mindset: Investing against the market will not come easily to those who are easily swayed by peer pressure, since they will have to buy, just as other investors (the peer group) will be selling, and often in companies that the market has turned against. There are  some who march to their own drummers, willing to take a path that is different from the rest, and these are better suited to being contrarians.
2. The Time Horizon: To be a contrarian, you don't always need a long time horizon, since corrections can sometimes happen quickly, but you have to be willing to wait for a long period, if that is what is necessary for the correction. Relatively few investors have this capacity, since it is determined as much by your circumstances (age, health and cash needs) as it is by your personality.
3. The Stomach: Even if your buy decision is based on the best thought-through contrarian investing strategies, it is likely that in the aftermath of that decision, momentum will continue to push prices down, testing your faith. Without a strong stomach, you will capitulate, and while your decision may have been right in the long term, your investment will not reflect that success.

As you can see, the decision on whether to be a contrarian is not just one that you can make based upon the evidence and theory, but will depend on who you are as a person, and your makeup. 

    I have the luxury of a long time horizon and the luck of a strong stomach, for both food and market surprises. I am not easily swayed by peer pressure, but I am not immune from it either. I know that buying stocks in the face of market selling will not come easily, and that is the reason that I initiated limit buys on three companies that I have wanted to have in my portfolio, BYD, the Chinese electric car maker, Mercado Libre, the Latin American online retail/fintech firm, and Palantir, a company that I believe is closest to delivering on thee promise of AI products and services. The limit buy kicked in on BYD on April 7, when it briefly dipped below $80,  my limit price, and while Palantir and Mercado Libre have a way to go before they hit my price limits, the crisis is young and the order is good until canceled!

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