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 (NYSEARCA: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.