As we have been
describing in weekly blog posts, the tailwinds are - in our mind - good for
stocks. Those are:
- When the dust clears - interest rates are going to stay low. We projected they would stay around 2.5% to 3.0% and that has held true. The 10-year Treasury is now trading close to 2.6%. Low interest rates will continue to push investors into stocks.
- The economy continues to muddle along, which is a modestly good thing for stocks - as it prevents bubbles from forming and also keeps the Fed engaged in stimulative monetary policy.
- Year-end earnings and dividend growth projections continue to hold in solidly positive territory. According to Yardeni Research, 2014 earnings growth is now projected at 11.3% and 10.2% in 2015.
The most obvious
headwind of today’s market is the Government shutdown and looming debt ceiling
debate. We spent the majority of our
time in the Monday meeting going through the different scenarios that may play
out.
Most Likely: Government Shutdown Will be Solved
In our opinion,
the most likely scenario is that this Government shutdown will be resolved
within two weeks or so. There is too much
on the line for both parties to allow it to go on for long. We suspect one party will start to see
political polls coming in placing the blame on either Republicans or
Democrats. The blamed party will start
taking action towards getting the Government back up and running and the blame
off of their shoulders.
If that were the
case, this Government shutdown would be much more of a political event than an
economic one. The stock market looked
through last year’s Fiscal Cliff and sequestration. We expect it will look through this event as
well.
Unlikely: Government Shutdown Runs into Debt Ceiling
In our minds,
the more dangerous event is the debt ceiling on October 17th. If the Government were to actually default on
U.S. bond obligations, we believe there would be a heightened increase in
volatility. Investors would express
their displeasure at an irresponsible, stalemated Government.
Even in the low
probability that a default would occur, we believe the markets would recover
sharply if the problem were solved within a matter of a few days.
Highly Unlikely: Default
The absolute
worst-case scenario is that the U.S. Government was to default on its loans and
interest would not be paid out to investors - many of whom are foreign
governments. The odds of that happening
are extremely low. We can’t imagine members
of either party would want the loss of full, faith and credit of the United
States of America to be marked on their legacy or conscience.
What Does it Mean for the Stock Market?
Historically,
Government shutdowns have had little impact on the markets. Since 1976, there have been 17 government
shutdowns lasting as long as 21 days.
The average decline for the S&P 500 for shutdowns of 5 days or less
is 1.4%. The worst shutdowns (10+ days)
dropped market prices by an average of 2.5%.
No government
shutdown has ever caused a stock market meltdown and it’s unlikely this one
will be any different. The market
appears to agree, as yesterday’s sell-off reaction to looming Government shutdown
was a modest -0.6%. At the time of
writing, the S&P 500 (SPY) was trading near its opening price on Monday morning.
Our Dow Jones
Industrial Average model is already trading considerably under our current
valuation models’ statistical predicted midpoint of 16,400. Short of an actual default - which barely has
any probability – we believe the worst the market could correct in response to
the Government shutdown and debt ceiling debate would be approximately the same
as when the Fed started taper talks in May – about 6%.
Despite any
long-term turbulence that may be created by our friends in Washington, the
long-term outlook for the stock market is still very positive. The Fed has strengthened its position on
stimulative monetary policy and low interest rates. Most importantly, expectations are holding
for improving company fundamentals. As
long as long-term earnings and dividends continue to rise, market prices will
follow.
