Who Rules the Post-Shutdown Market?

Sheraz Mian

The current air of uncertainty and tentativeness will lift only after the current impasse comes to an end. But what happens to the market afterwards - once sanity returns to Washington?

This article was originally published by Zacks.com.

We know that Washington likes to take the country to the brink with its partisan ideas before pulling back at the last moment. This time is likely no different. The current budget fight has started weighing on the market, but the losses are modest and the indexes aren't that far from all-time highs achieved recently.

The current air of uncertainty and tentativeness will lift only after the current impasse comes to an end. But what happens to the market afterwards — once sanity returns to Washington?

Most investors are quite bullish, as they see stocks reaching new highs later this year and next year on the back of improving fundamentals and diminishing risks. Others are not so sanguine and cite the sub-par corporate earnings picture and other macro challenges coming the market's way.

These contrasting views beg the question of where we go from here, particularly after the current Washington Brawl. And that's my goal in this piece — to survey the landscape of bullish and bearish arguments to help you make up your own mind.

The bull case

1. The negatives are already priced in

This means the sum total of all bad or negative news about the U.S. and global economy is already well known and reflected in current prices. It seems quite plausible since questions about the Fed and the outlooks for the U.S., China and the eurozone have been around for a while now and are no longer “news” to any market participant.

2) Economic and earnings pictures quite healthy

We didn't get the September jobs report due to the shutdown, but other data has been broadly reassuring. GDP growth in Q3 will most likely fall short of what we saw in the preceding quarter. But the outlook remains favorable, with growth expected to steadily improve from Q4 onwards. The corporate sector is in excellent shape, with estimates for total earnings in Q3 not far from the previous quarter's all-time record and the growth rate expected to ramp up in the coming quarter.

3) Central bank 'put'

Some questions about the future of the Fed's QE program notwithstanding, the overall monetary policy stance across all the major economies, including the U.S., remains favorable and supportive of the market. This means that even after the Fed starts “tapering” the QE program later this year, it will continue to keep short-term interest rates at the current near-zero level for a very long time.

The bears’ response

1) Market is pricing a best-case scenario

Market prices reflect consensus expectations, and current consensus expectations for GDP and earnings growth are clearly on the optimistic side. Europe has stabilized a bit, but the region will likely continue to struggle for a long time. The situation isn't that better in China either, where the best-case scenario is a stable economy that will grow at rates significantly lower than what we saw in the past decade.

The rest of the BRICs appear to have hit a wall as well, which is having knock-on effects all over the world. It is way too optimistic to assume that the U.S. economy and corporate sector can gain momentum in this backdrop.

2) Economic and earnings pictures far from healthy

The U.S. economy is no doubt doing better relative to the rest of the world, but that's nothing more than what the cleanest-dirty-shirt analogy tries to convey. Housing and the labor market are doing better, but GDP growth is unlikely to materially improve from what we have experienced lately.

On the earnings front, don't let the optimistic consensus estimates for Q4 and beyond distract you from the fact that the picture is hardly in good shape. Popular stock market valuation multiples, which the bulls never tire of citing as proof of under- or fair valuation, will start showing otherwise once more realistic earnings estimates are used.

3) The Fed is in a bind

The Fed surprised everyone by not tapering at its last meeting, but there is no doubt that QE can't continue forever. Investors have become so accustomed to the Fed pumping liquidity in the market that they see no difference between “tapering” and “tightening.” The non-taper decision has helped stall the uptrend in long-term interest rates, but they remain elevated relative to just a few months back.

The Fed's recent inability to effectively communicate its intentions about the QE program is likely a sign of things to come as they eventually move towards unwinding the extraordinarily accommodative policy of the last few years.

Where do I stand?

As regular readers know, the bearish case makes more sense to me than the alternative. Simply put, I find it hard to envision stocks holding their ground in the current sub-par corporate earnings backdrop. The market hasn't paid much attention to the persistent negative earnings estimate revisions over the past year or so, likely on the assurance of continued Fed support. But with the Fed on track to get out of the QE business in the not-too-distant future, they have to start paying attention to corporate fundamentals.

Keep in mind, however, that being bearish doesn't mean that you have to exit the market altogether. There is always an opportunity to make money somewhere in the market. You could go long when you feel bullish or go short when things don't look so reassuring, or you could load up on defensive stocks or get more aggressive. Keep in mind that you are not restricted to the domestic market as you can always diversify into international markets when opportunities warrant.

Sheraz Mian is the Director of Research for Zacks and manages our award-winning Focus List portfolio. He is among the experts whose recommendations appear in Zacks Confidential.

The information supplied above by Zacks Investment Research Inc. contains opinions based on factual research which may or may not be accurate. Neither Zacks nor Intellisphere will assume any liability for losses from investment decisions based on this information.

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