U.S. downgrade deflates value of ALL investments

Waking up to headlines like this can be scary:

US debt talks teeter on edge of collapse

Experts say buy gold or keep plenty of cash. But few explain the reason why all cash-flow dependent investments will suffer when the credit of the world's largest economy is downgraded.

Here's the not-so short and sweet: When you value a company, or stock, you have to estimate its future cash flows. Obviously, the more expected cash flows, the more valuable the company. But, in order to get the value that you'd pay Today for that company, you must discount those cash flows -- meaning future cash flows are less valuable today. (The old bird in hand saying)

The discount rate almost all financial experts use to discount cash flows is the "risk-free" rate on U.S. government treasuries (U.S. debt). When the U.S. defaults, the ratings agencies (S&P) lower the country's credit rating. Investors in our debt demand to be paid a higher rate of interest in return. And the borrowing cost to the government, and this discount rate, goes up. When the discount rate rises, the value of ALL future cash flows goes down.

Now the two big questions are: Will government debt actually be downgraded, and if so how much will this discount rate rise?

My feeling is that even if the government comes to some last minute agreement to raise the debt ceiling, ratings agencies have already committed to downgrading our debt based on fundamentals. So yes, I think that barring some miracle (like Washington agreeing to the types of dramatic cuts in spending and tax increases needed, but that will cost them their jobs) the U.S. will be downgraded.

How much will investments suffer? I don't think a 5% to 10% correction is out of the question.

I've positioned our portfolio at a tactical non-commitment level of 50% market, 50% mattress. If you are on a shorter-term investment horizon (retirement looming) you should be even more conservative.

Sell all funds that hold primarily U.S. government treasuries, except inflation protected bonds. Maintain international exposure. Look to invest in Swiss-backed government debt (safest in the world). And, if you're uncertain completely, keep your money in an FDIC-backed CD.

Here's the kicker. When the government eventually raised the debt ceiling (and they will), get ready to unload some of your investments. It will be difficult. The market will jump on the news. There will be elation and hope for a resurgence in domestic growth. But nothing ever lasts.

"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." -- Warren Buffett