S&P punctures bubble! What to sell and what to buy …

The first-ever downgrade of U.S. debt, announced Friday by Standard & Poor’s, hit Asian stocks hard last night and is about to slam into U.S. markets at the opening bell a couple of hours from now.

That’s what’s going to grab the headlines, and that’s what everyone’s going to be talking about today.

What most people don’t realize, however, is that S&Ps downgrade could have an even more devastating impact in a far larger market — the debt market.

The debt market runs the world. It includes tens of trillions of dollars of government debts, corporate debts, and consumer debts.

With a stable debt market, the global economy grows; without a stable debt market, the global economy comes to a screeching halt and collapses.

And at the core of the global debt market are U.S. Treasury bonds. If Treasury bonds rise in value, so do nearly all other forms of debt. If they fall, they drag down the entire market. There is no other likely scenario.

The big problem: Treasury bonds are now a giant bubble; and by downgrading Treasury bonds, S&P has just punctured it.

What Created the Treasury Bond Bubble?

Answer: The same types of forces that created the tech bubble in the late 1990s and the housing bubble in the early 2000s:

Wild growth: Just in the five years from 2008-2012, Treasuries outstanding will have grown by $5.6 trillion. Amazingly, that’s $1 trillion more than the growth in all 232 years of America’s existence before 2008.

Artificial props: Treasury-bond prices have been artificially pumped up by a series of unprecedented government efforts — first, when the Federal Reserve pushed short-term interest rates down to nearly 1% in the early 2000s, driving up bond prices … second, when it shoved rates down to zero in the mid-2000s … and now, with its bond-buying rampages called “quantitative easing.”

A sudden influx of new investors: Treasury-bond prices have been pumped up even further by investors who historically never invested heavily in U.S. government bonds — foreigners who were forced to buy the bonds simply because they had no other place to put all their unwanted dollars.

And unbelievably, according to the Treasury Department, foreign investors now hold $4.5 trillion in U.S. government securities, with the largest single chunk — $1.2 trillion — held by China.

False claims: And, alas, Treasury bonds are a bubble because they’ve been supported by the inflated triple-A ratings of Wall Street’s three credit rating agencies, creating a false aura of safety, misleading investors about the true risks, and leaving the entire market extremely vulnerable to downgrades.

We demonstrated exactly how and why the triple-A ratings are deceptive when we publicly challenged S&P, Moody’s, and Fitch to downgrade the U.S. government’s long-term debt 15 months ago:

They fail to reflect a rapid deterioration in U.S. government finances since the debt crisis of 2008. They give higher grades to the U.S. than other countries with superior finances. They ignore the large risks Treasury-bond investors are taking with the dollar, a bond market collapse, illiquidity and the surging cost of insuring against default. And they overlook a series of other risk factors. (See The Weiss Ratings Challenge.)

We explained it again when we rated U.S. debt a “C” (equivalent to S&Ps BBB) on April 28. (See Introducing the Weiss Sovereign Debt Ratings.)

And we did it a third time when we downgraded U.S. debt to C- on July 15 (press release).

Here’s the key: By their very nature, bubbles are extremely fragile. All it takes is the removal of just ONE of its supports and the bubble is punctured.

And that’s precisely what may have happened Friday afternoon when Standard & Poor’s ended the era of triple-A for the government of the USA.

Our recommendation: If you’re still holding medium- and long-term Treasuries despite our advice, take advantage of the flight-to-quality rally of the past couple of weeks and dump them now.

Or at least consider hedging your government bonds with an inverse exchange-traded fund designed to rise when Treasury-bond prices fall — such as TBF (rises 1% for every 1% decline in 20-year T-bond prices) or TBT (rises 2% for every 1% decline).

Plus, in the days ahead, if you want to better gauge the global reaction to the S&P downgrade, the first market you should look at is not stocks, commodities, or the dollar. It’s the Treasury-bond market.

With the U.S. economy sinking, with much of Europe collapsing, and with global investors rushing to buy Treasury bonds for safety, you’d normally expect their prices to surge.

If they don’t surge — or if they actually decline — it will be your first signal that this giant bubble may have been punctured by the S&P downgrade, with far-reaching consequences …

Consequence #1
Disappearing Credit

Everyone seems to recognize that the S&P downgrade is a factor which will put upward pressure on borrowing costs for everyone.

But it could be much worse than that — not just higher interest rates, but also a sudden exodus of lenders, making it impossible for most borrowers to get credit at almost any cost.

We saw this happen in the mortgage meltdown, when most banks virtually shut down their home mortgage lending for everyone regardless of credit rating.

We saw it again in the wake of the Lehman Brothers failure. Thousands of institutional investors, who typically make short-term loans to America’s largest corporations, recoiled in horror. So the market for these short-term loans, called commercial paper, froze up and nearly died, threatening to instantly bankrupt hundreds of big banks and manufacturers.

We saw it happen again just last week as American investors, fearing a federal government default, suddenly withdrew $70 billion from money market funds. That was the biggest net outflow since 2008.

And we may see a similar pattern in the days ahead.

Our recommendation: If you’re planning to invest in a business, buy real estate, or just refinance, don’t count on getting credit. Either be prepared to use cash or, better yet, seriously consider canceling your plans entirely. Depending on your situation, it may be a blessing in disguise; investing in this turbulent environment is too risky anyhow.

Consequence #2
Collapsing Municipal Bonds

If the federal government is downgraded, what happens to the bonds issued by local governments that get federal aid, guarantees, or supports?

S&P says it will consider up to 7,000 for downgrade. Result: A major rout in the municipal bond market.

Our recommendation: Sell. Just bear in mind that the market for many municipal bonds can be slim and illiquid. So if that’s the case for your munis, give your broker the opportunity to work your sell order to get fair bids.

Consequence #3
Collapsing Corporate Bonds

If even Treasury bonds, always thought to be the gold standard of safety for the entire world, are no longer fool-proof, what about corporate bonds, which are almost invariably lower rated?

Given that U.S. corporations operate under the U.S. financial system, tax system, and legal system, is it even possible for an ordinary American corporation — no matter how big or strong — to actually be safer than the mighty U.S. government?

Some say “yes.” Some say “no.”

But the answer is immaterial. Because to cause a panic in the corporate bond market, all you need is a small minority voting “no” with their dollars and running for the hills.

Indeed, a sneak preview of that panic has already begun in the junk bond market: HYG, the exchange-traded fund that tracks junk bonds, has plunged from a high of nearly 92 on July 22 to a closing low under 87 this past Friday. That’s its lowest level in over a year.

Our recommendation: Also dump corporate bonds. They may be less volatile than common stocks in the same company. But “losing less money” is not our idea of a positive goal.

Feeling stuck? Unwilling or unable to sell your bonds for some particular reason? Then seriously consider using inverse ETFs that go up when your corporate bonds fall.

If you own junk bonds, you can use SJB, which tracks the iBoxx $ Liquid High Yield Index. For every 1% decline in the index, SJB is designed to rise 1%.

Or if you own investment grade corporate bonds, you can use IGS, which does the same for the iBoxx $ Liquid Investment Grade Index.

In either case, the more the index falls in price, the more your investment will rise.

Consequence #4
Bad News for U.S. Stocks

They’re already falling due to the sliding economy and plunging consumer confidence. Add rising interest rates or credit market disruptions to the mix — and the market is suddenly under a red “crash warning.”

So if anyone tells you there’s going to be a flight to quality that drives investors from bonds into stocks, tell him to take a hike.

Common stocks are inherently riskier than corporate bonds and far riskier than Treasury bonds.

Yes, some may have believed Wall Street’s assurances that “stocks are a safe bet for your retirement.” But now most are asking: “If even Treasury bonds are not nearly as safe as we thought, how can anyone say common stocks are any better?”

Afraid of a crash? Looking for a way to get out or reduce your risk substantially?

It doesn’t matter if the next big stock market crash begins this morning or not. Nor should you feel remorse for not acting on our sell recommendations sooner. They still apply right now …

First, reduce your risk by selling, on average, about half of each stock position right away. (There may be some exceptions. But we’ll leave that up to you and the Weiss Research editor you’re following.)

Second, for the balance of your holdings, determine which stocks are probably the most vulnerable by checking their rating at www.weisswatchdog.com. Then …

•  If you’re not a member, sign up. It’s free to our readers.

•  At the top of the screen, select “stocks.”

•  Enter the FIRST word of the company name and press “search.”

•  Add your stocks to your watchlist and then go to the watchlist to see the rating.

•  If it’s D+ or lower, we would seriously consider selling the rest on any rally in the market. If it’s a B+ or better, it should have a much better chance of holding up better than the rest of the market.

Just be aware that the rating is not the ONLY factor to consider.

Third, no stock — no matter how highly rated or how special — is risk free. All can be vulnerable to stock market crashes, as investors dump the baby with the bath water. So to protect yourself against that risk, consider inverse ETFs as a hedge.

For example, you can use SH for broad protection against a decline in the S&P 500 … DOG for a portfolio that’s overloaded with Dow Jones industrials stocks … or PSQ if you’re heavy into the Nasdaq.

The goal: The more your stocks fall, the more your inverse ETFs rise, helping to offset your losses and give you pretty good protection.

What do you do if all your retirement funds are tied up in a 401(k) with limited investment choices? Then switch most of your funds to a money market or buy the inverse ETFs in a separate taxable account.

Consequence #5
Falling Dominoes

The S&P downgrade could be just the first domino — merely a metaphor for the historic, life-changing, world-changing transformations that could vaporize massive amounts of wealth and create equally massive new fortunes.

Ironic, isn’t it? Just one voice — declaring loudly that the emperor has no clothes — could be enough to rock the entire kingdom.

That voice may turn out to be S&P’s. Or it may be another. But the underlying cause of the ensuing catastrophe is not the voices that speak the truth. It’s the reality of the great bond-market bubble that the U.S. Congress, the Treasury, the Federal Reserve, and the established rating agencies have created.

Best wishes,

Martin and Mike