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By Christine Benz | 08-08-2011 12:17 PM

Top ETF Picks for the Downgrade

Morningstar's Scott Burns discusses why S&P's move was not surprising and where investors can look for ETF and CEF values today.

Christine Benz: Hi. I'm Christine Benz for Morningstar. Stocks have continued to sell off sharply this week. Here to discuss what's driving the weakness as well as whether it's created any pockets of buying opportunities for long-term investors is Scott Burns. Scott is a research director here at Morningstar. Scott, thanks so much for being here.

Scott Burns: Christine, thanks for having me.

Benz: So, Scott, first of all, S&P came out with this ratings downgrade for U.S. Treasuries on Friday night. I'd like your take on what the implications of it are and whether you think that that's the thing that's putting downward pressure on stocks right now?

Burns: Right, well, it was definitely a headline-grabbing move. I don't think it was really surprise to anybody. I think we had been seeing a lot of movement in that direction. In fact, just last week or the week before, the Chicago Mercantile Exchange, one of the largest of futures and options markets, had actually started to require investors to haircut their Treasuries in collateral by 5 basis points. So we had already seen the kind of actual downgrade going through right now.

Whether it's AAA or AA+, I don't think it necessarily really matters. It's still the biggest pool of investment-grade securities out there for people to use as collateral, but I do think there is a psychological effect going on right now with the downgrade. But at the end of the day Monday, markets were selling off again in the equity market and Treasuries were rallying after the downgrade. So, to me, that says that it's really more about the eurozone debt crisis and, frankly, I think more about the economy with some of the mixed economic numbers that we've been getting.

Benz: The economy here in the U.S. as well as in developed foreign markets?

Burns: Right, and it rolls through everything. So, I think the one number really to keep an eye on was that inventory number. What we had in 2008 and 2009 were corporations which cut their manufacturing to the bone so much that we actually had a shortage for a little while. We had to rebuild some of those stocks and those inventories.

As that started to flatten out now, what we're seeing is kind of that real economic demand, and things are flattening out. I'm concerned about inventories in general but the autos sector more in particular. So, one effect of the downgrade that it's going to have, whether psychological or real, is that costs of borrowing are going to go up. In fact, what the CME really did is a margin call on everybody. That was just a broad-based margin call.

If you have the mutual fund that owns futures or options that trade through the CME, the cost of those just went up. If you're investing in a fund or you have someone else who is borrowing money from somewhere else, their cost have gone up and therefore your returns have gone down.

So, a lot of what we're seeing I think is actually just the effects of "little i", which is the risk-free interest rate, and one of the axioms of finance theory is that "little i" is the biggest lever in everything. So, if "little i" goes up, all asset prices must go down. "Little i" is in CAPM; it's in Black Scholes. It's in every asset-pricing model.

Benz: We have seen with this recent sell-off that some of the more cyclically oriented companies have sold off the hardest as well as small caps have really taken it on the chin?

Burns: Yeah. We've really seen and this, again, it echoes November of '08 and even March of '09 to a certain extent this kind of flight to quality. While Treasuries are still going up and people are scratching their heads about that, maybe it's just the best pig in the poke right now. So, it's definitely the deepest. But we've also seen value large-cap U.S. stocks that are globally diversified holding up better than that small cap and that mid cap; we've definitely have seen a much more outsized flight to quality in those areas of the market.

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