Budget agreement and debt ceiling derail stock market

It’s just your money. It’s not your life. The figures on a broker’s report mean little compared to that. The people who loved you a week ago still love you today. – Louis Rukeyser – referring to Black Monday Oct. 19, 1987

So far all of the major events that could have negatively impacted the stock market in the last few weeks have failed to happen. Military action with Syria was averted through diplomatic means; the Federal Reserve decided not to reduce its $85 billion-a-month bond buying program, assuring continued easy money for the foreseeable future; Larry Summers withdrew his name from consideration to succeed Ben Bernanke as Chairman of the Federal Reserve, making Janet Yellen the likely successor to continue the highly accommodative Fed policies; German Chancellor Angela Merkel won reelection by a wide margin, ensuring continuing economic recovery in the Eurozone; and, finally, talks took place between President Obama and the president of Iran for the first time since 1979. While all of these outcomes have been favorable for stocks, the budget deadline and the debt ceiling are the final hurdles and their outcome is far from certain. Last week markets were relatively calm and reacted as if a government shutdown would be averted. However, as of this writing, it looked more and more like a shutdown would occur unless an eleventh hour deal could be reached to keep the government operating. Without some kind of deal, the string of successful outcomes favorable for the stock market will have come to an end. Increased volatility will likely occur until a deal is struck, at which time investors can focus again on the economy and third quarter earnings, which begin in earnest with Alcoa’s report next week.

Last Week

In anticipation of budget showdown this week, the stock market closed modestly lower last week despite the fact the economic data was mostly positive. Home prices in the U.S. climbed at the fastest pace in more than seven years in July and sales of new homes increased in August. Existing home sales, however, were weaker than expected and could be partly due to higher mortgage rates. Manufacturing data both in Europe and in this country continued to point to continued growth, albeit at a modest pace.

In another hopeful sign for the U.S. economy, consumer spending and personal income both rose in August. Since consumer spending represents as much as 70% of the U.S. economy, this economic data could foreshadow higher GDP growth in the third quarter. Jobless claims also declined for the week and durable goods orders rose modestly, both providing evidence of sustained economic growth.  

For the week, the Dow Jones Industrial Average lost 1.3% while S&P 500 Index declined 1%. The Nasdaq, however, finished the week higher but only marginally.

This Week

Economic data will again take a back seat this week to the political wrangling in Washington over the budget and continued operation of the government for the next fiscal year. The deadline to reach an agreement is midnight on Monday Sept. 30^th. The not-ready-for-prime-time Affordable Care Act also becomes reality as people can begin to sign-up for insurance on health care exchanges. This law remains the biggest obstacle in reaching a budget agreement between Republicans and Democrats.

Usually the monthly employment data is the main focus of the week, but it’s likely to receive second billing this week. Economists expect the number of new jobs created to be about 180,000 and the unemployment rate to remain unchanged at 7.3%. Other manufacturing data that is released should be favorable and supportive of a manufacturing sector that continues to expand. Corporate earnings reports are few and far between, but Walgreen is expected is report strong fiscal fourth quarter earnings.

Portfolio Strategy 

Here we go again. Although it is expected that our politicians will act like adults and hammer out an agreement before the clock strikes twelve, it shouldn’t be a surprise if they turn into pumpkins like in a famous Disney movie. Until some sort of compromise is reached, there is likely to be downside risk to stocks in the week ahead. In many ways, what is happening in Washington should be viewed as merely a sideshow intended to distract investors from what is really important, namely the economy and corporate earnings. On that basis, the performance of the stock market will depend on third quarter earnings as well as guidance on future earnings and, more importantly, revenue growth. As long as companies meet or beat earnings estimates and are positive on their prospects going forward, stocks should do just fine as their valuations are still reasonable. Fed policy also trumps the shenanigans in our nation’s capital and with regard to that, all indications are that an accommodative policy will remain in place until the economy has strengthened enough to take the foot off the gas.

Lost in all of the focus in Washington has been the performance of bonds. Quietly, the yield on the 10-year Treasury note has declined to 2.61% from a high of 2.90% before the Fed meeting. This move lower in rates has caused the value of fixed income securities to rise and erased some of the losses that existed in individual bonds and bond funds. Municipal bonds and corporate notes with maturities less than five years still offer good value as credit risk, or the risk of default, remains miniscule. Corporations still have strong balance sheets and their bonds are still attractive given the low level of inflation that currently exists.