Republicans and Democrats agreed to budget cuts and a promise to pursue more deficit reduction actions in exchange for raising the debt ceiling. As you know, the legislation is universally disliked. What it does do, however, is make it harder for Congress and the president to do something about the economy. Additional tax cuts or spending will need to be offset in some manner, especially with the credit rating agencies breathing down Uncle Sam’s neck.
Legislation often has unintended consequences. The debt ceiling law has the potential to throw a wrench in to the presidential cycle for stocks. The third year of a presidential term has historically been good for investors, with the Dow Jones industrial average appreciating every time since 1939. Jeff Hirsch, author of “The Stock Trader’s Almanac,” says that this is because presidents seek to make voters happy ahead of forthcoming elections.
Often, presidents have pushed for some type of economic stimulus. Jeff told me yesterday that the markets have also historically reacted to a cooperative environment in Washington that puts the U.S. in a good place. This has included actions involving both domestic and foreign issues.
Given the conflicting personalities and ideologies in Washington, cooperation among politicians remains in short supply. At the same time, President Obama now has to balance potential future economic initiatives with long-term debt reduction desires. Any proposal, whether it involves spending (e.g., job training, infrastructure, extended unemployment benefits) or tax cuts and expenditures (e.g., extending the 2% payroll tax cut, allowing corporations to repatriate foreign profits) will impact the trajectory of our government’s debt.
This is not to say that the 72-year streak of positive third-year presidential term gains for the Dow will be broken. The economy could recover from its recent slump and/or President Obama and congressional Republicans could find more middle ground. There is also the potential for positive developments in Europe, Japan and the Middle East. (I know some of these are long shots.) Plus, valuations for large-cap stocks are cheap relative to projected earnings.
If part of your investing strategy this year is based on the presidential cycle, you need to acknowledge that things are not going as planned. Streaks last until they don’t. Similarly, if your investing strategy is based on an economic recovery, you will need to acknowledge that growth has slowed. None of this is to say that you should get out of stocks, but rather that you should factor in higher downside risks. Pay attention to valuations and to business trends. Be wary of those companies that are losing market share, as opposed to simply experiencing slower growth because of the economy.
As far as the impact of the debt ceiling legislation on your portfolio, monitor companies that are dependent on government spending. (If you are unsure about the percentage of revenues that come from the federal and state governments, read through the company’s annual 10-K filing with the Securities and Exchange Commission.) Though the cuts will only have a small short-term impact, they could reduce earnings for 2012 and beyond. Be on the watch for downward revisions to earnings estimates.
AAII Sentiment and Asset Allocation Survey
The Week Ahead
Approximately 20 S&P 500 companies will report earnings next week as earnings season begins to wind down. Two Dow components are included in this group, Walt Disney (DIS) on Tuesday and Cisco Systems (CSCO) on Wednesday.
The week’s first economic report will be second-quarter productivity, which will be published on Tuesday. Wednesday will feature June wholesale trade data. June international trade numbers will be published on Thursday. Friday will feature July retail sales, the preliminary University of Michigan consumer confidence survey, and June business inventories.
The Federal Open Market Committee will hold a one-day meeting on Tuesday. No Federal Reserve officials are currently scheduled to make public appearances next week.
The Treasury Department will auction $32 billion of three-year notes on Tuesday, $24 billion of 10-year notes on Wednesday and $16 billion of 30-year bonds on Thursday. These will be the first Treasury auctions since the debt ceiling was raised.
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