By Wallace Witkowski, MarketWatch
SAN FRANCISCO (MarketWatch) -- Investors will need to fasten
their seat belts in the coming week because whether or not the
government shuts down Tuesday, the process is going to be
bumpy.
Markets have already been responding to the political posturing.
In the past week, stocks posted their first weekly drop since
August, with the Dow Jones Industrial Average (DJI) and the S&P
500 Index (SPX) closing down 1.3% and 1.1%, respectively. The
Nasdaq Composite Index (RIXF) managed to squeak by with a 0.2%
gain.
On Friday, President Barack Obama urged House Republicans to
avoid a government shutdown, stressing that even the threat was
dragging on the economy. Earlier in the day, the Senate voted
54-to-44 on a measure to keep the government funded until Nov. 15
without provisions to defund Obama's health-care law that had
passed in the House earlier.
"Right now, we're just going through this kabuki dance before
midnight Monday because the government could shut down Tuesday,"
said Phil Orlando, chief equity market strategist at Federated
Investors.
How low can stocks go?
Expect the S&P 500, which closed at 1,691.75 on Friday, to
slide between the range of 1,600 and 1,650 over the next month -- a
drop of 2.5% to 5.5% -- depending on how ugly things get in D.C.,
Orlando said. The 1,600 limit of the range becomes likely if there
hasn't been any debt-ceiling resolution by Oct. 17, when Treasury
Secretary Jacob Lew said the U.S. will be dangerously low on cash
to pay its bills.
In comparison, the last time there was a government shutdown was
Dec. 13, 1995 to Jan. 10, 1996, and the S&P 500 dropped 3.7%
over that period, only to snap back up 10.6% by mid-February,
according to a recent note by S&P Capital IQ.
Read: Fret the debt ceiling, not shutdown-- in charts
Sectors that have been pushed up lately from a valuations
perspective will likely be the most vulnerable to a government
shutdown, Orlando said, citing examples such as consumer
discretionary, finance, tech, industrials and energy.
A shutdown would hit stocks during an already hobbled economic
recovery, Orlando noted. Over the last nine recessions, GDP growth
has averaged about 4.4% four years after the recession, compared
with the current 2.5%. Given the logic that a deeper recession
should have a bigger bounce back, Orlando said gridlock over fiscal
policy has sapped much of the recovery's strength, referencing a
speech New York Fed President Dudley gave earlier in the year.
Dudley said that the government's biggest policy mistakes,
raising tax rates, the sequester, and the Affordable Care Act --
would impede GDP by about 1.75%. Coincidentally, that accounts for
much of the deficiency from the average, Orlando noted.
Convinced a shutdown's inevitable? Follow the [lack of]
money.
If you're convinced that the shutdown is going down, then you
might want to give those government-dependent stocks in your
portfolio a second look, said Frank Fantozzi, chief executive of
Planned Financial Services in Cleveland, Ohio. Otherwise, stay the
course and deal with the choppiness that's going to come out of
negotiations going down to the wire.
Fantozzi is more concerned about collateral effects of the Fed
not tapering in September, calling the decision not to start easing
off asset purchases a "very bad signal."
"It's a self-fulfilling prophecy," Fantozzi said. "The Fed comes
in and says the economy is not healthy. Well, if I'm a business
owner, should I be hiring and spending?"
Speaking of the economy, there's the question of what happens to
economic reports -- basically, a crucial link in gauging the pace
of the economic recovery -- if the government shuts down. For
instance, the Friday jobs report would likely get delayed.
If you're banking on the government shutting down for any
appreciable period of time, Goldman Sachs advised in a recent note
to start buying puts on some overlooked stocks with high government
exposure as a hedge against the shutdown. Companies deriving more
than 20% of their revenue from the government start appearing on
the firm's radar.
Some of the companies most dependent on government for revenue
are Harris Corp. (HRS) with 80% of revenue government-derived;
Granite Construction Inc. (GVA) with 58%; Flir Systems Inc. (FLIR)
with 54%; and Waste Management Inc. (WM) and Republic Services Inc.
(RSG) both with 50%, according to Goldman Sachs.
Barclays analysts told investors to expect volatility with a
mild negative bias against stocks until the risks of a government
shutdown and debt-ceiling default clear, according to a recent
note. Even if nothing happens, meaning the posturing ends up being
posturing and the 11th hour deal is struck, the posturing itself is
beginning to wear on markets.
Barclays said "the perpetual conflict and political discord of
recent years has led to increased uncertainty, sizeable fiscal
drags in the resolution (eg, sequestration), and temporary market
disruptions. In other words, recent experience tells us the risk
need not be fully realized in order to affect financial markets;
walking close enough to the edge is sufficient."
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