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Credit Rating Agencies Forget Markets Look Forward

Many of Friday’s headlines read like this:

Bank Downgrades in U.S. Prove Mistaken as Credit Risks Wane

It’s not so much (or perhaps, not only) that Moody’s, Fitch, and S&P are “mistaken” about the banks—it’s that they’re pretty much always the last to recognize reality and reflect it. That’s because, by and large, credit rating agencies pretty much do as human brains are wont: take the recent past and extrapolate it into the future.

This is one of the foremost and ultimate investing mistakes. Capital markets look forward and price in the expected future. Credit ratings agencies are reflecting today in their ratings what’s already done and past about the banks. They, like most folks, are not able to see clearly the future, and therefore use the recent past and assume trend continuation.

Oh, they’ll have their fancy models, special analysts with their special techniques, and other secret sauces to confirm and give authority to their prognostication. But in the end, credit ratings tell you more about the past than the future—making them awful forecasting tools.

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