Government gridlock sends stocks lower

You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets. – Peter Lynch

Normally, investors would be focused squarely on the third quarter earnings season, which begins this week with Alcoa’s report on Tuesday, to ascertain clues about the future direction of stock prices. But their attention has been diverted by the politicians in Washington as the government shutdown  enters its second week with no resolution in sight. While gridlock in our nation’s capital can create a lot of anxiety, it should be put in perspective and not detract from what really matters with regard to the stock market, namely corporate profits and the health of the economy. By law, Congress must pass a budget on time or suffer the consequences of a government shutdown if it fails to do so. Since 1981 when President Ronald Reagan did battle with Congress over taxing and spending, there have been eleven shutdowns. While the idea of a shutdown seems ominous and scary, market reaction is generally muted and stocks usually post gains of about 3% after things are resolved. Stocks are likely to be weak until a deal is done but investors would be wise to stay the course and rest assured that this, too, shall pass.

Last Week

With failure to reach an agreement on the budget by midnight on Monday, the U.S. government officially shut down for the first time since 1995. As a result of the shutdown, global markets were relatively weak across the board as uncertainty over the length of the stalemate caused investors to sell risk assets and take cover in safe investments. On Friday, though, most investors were betting that the crisis would be short-lived and stocks rallied. Economic news was also very encouraging as the Institute for Supply Management (ISM) factory index reached a two-year high, signaling continued expansion in the manufacturing sector of the economy.

One consequence of the government shutdown was the absence of the employment report for the month of September, which is always released on the first Friday of the month. As a result, investors were forced to settle for the ADP report and the weekly jobless claims number. In both cases, the news was good but not great as fewer-than-expected private sector jobs were created and claims rose slightly but still showed strength in the labor market based on recent trends.

For the week, the Dow Jones Industrial Average lost 1.2% as the government shutdown weighed on investors’ nerves. The S&P 500 Index finished the week virtually unchanged while the Nasdaq actually rose 0.7%.

This Week

Although the primary focus this week will again be on our dysfunctional government, minutes from the Federal Reserve’s meeting in September will provide answers as to why the decision was made to forego tapering of its monthly bond purchases. A consumer sentiment index will also be released and is likely to show a decline due to anxiety by consumers over the ineptness displayed in Washington. Other economic data will include the Producer Price Index (PPI), which should indicate tame wholesale prices, and retail sales, which are expected to increase modestly.

With economic growth expected to be sluggish, earnings in the third quarter are likely to follow suit and only increase about 5%. Since corporate management has guided analysts’ earnings estimates lower for the quarter, it’s possible for more companies to actually beat these lower estimates, which may be positive for stocks. Among the most prominent companies reporting earnings this week are Wells Fargo and JP Morgan in the finance sector along with Alcoa, Yum Brands, Costco and Safeway.

Portfolio Strategy

While news headlines in the coming days will be dominated by the government shutdown and the potentially devastating consequences of a failure to raise the debt ceiling, investors should resist the urge to make any rash decisions with regard to their investments. The S&P 500 is only down about two percent from its all-time high reached in mid-September and, if history is any indication, stocks have always recovered from any weakness caused by these events in the past. That is probably why the stock market has been so resilient since the government ground to a halt a week ago. The question is not if the government will again reopen but when. Obviously, the longer this stalemate lasts, the more downside risk there is for the stock market. Since these events are typically short-lived, one should resist the temptation to sell equities with the intention of getting back in the market at a later date. Studies have shown that market timing is a loser’s game that rarely is successful. Not only does one have to be right in getting out of the market but knowing when to get back in is also fraught with risk.

With economic growth likely to remain constrained in the U.S. until the impasse in Washington is resolved, investors would be smart to look overseas for growth. Economies in Europe are gradually improving and companies are likely to begin reporting better earnings as the recovery takes hold. U.S. multi-national companies with significant exposure to Europe could also be the beneficiaries of stronger growth and see their revenues rise. A broad-based international fund with representation in the largest countries in the euro zone would increase the diversification of a portfolio, reduce its overall risk and provide for the potential of higher returns in the future.