Monday, September 30, 2013

Signs Raise Threat of a Red October

The U.S. stock market is in the doldrums, with the Dow Jones Industrial Average back at May levels. Little wonder.

In the coming month, markets face four huge tests: the Washington debt crisis, the release of September employment data, third-quarter earnings releases and the Federal Reserve's next policy meeting.

All four of these horsemen could disrupt investments, and some could tank the market. Money managers hope all will be nonevents and stocks will finish the year higher. But there are no guarantees. Many people are delaying decisions, with some betting on an October market dive. Optimists might use that as a chance to buy in cheaper.

"It wouldn't surprise me that the headlines over the next three weeks are dramatic enough that you could get a selloff," says Jason Trennert, founder of Strategas Research Partners in New York, who is urging clients to buy if stocks do decline.


The Washington mess is back on the front burner. Most immediately, Republicans in Congress are threatening to shut down government by refusing to fund government operations unless Obamacare is suspended. But the government has been temporarily shut down before without major financial-market damage. So investors worry less about this than about the risk that Congress could refuse to extend the debt ceiling later in the month.

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If the debt ceiling isn't raised, the Treasury Department says, it won't be able to pay bills past mid-October.

If the U.S. defaults on its bonds, even briefly or technically, U.S. and foreign financial markets could take a dive, money managers say. Because the consequences are enormous, most expect a compromise solution.

But a last-minute patchwork solution, as in the summer of 2011, might not prevent trouble. In 2011, Standard & Poor's Ratings Services downgraded U.S. Treasury debt to AA+ from AAA, citing the government's dysfunction.

Fitch Ratings warned this past June that if there is another pitched debt-ceiling battle, it could downgrade U.S. debt. "Failure to raise the federal debt ceiling in a timely manner will prompt a formal review of the U.S. sovereign ratings and likely lead to a downgrade," Fitch said.

Most bond-fund bylaws allow them to continue owning Treasury bonds as before, even after two downgrades, fund managers and analysts say. But a downgrade could roil financial markets, as happened in 2011.

"We are in the midst of this ongoing dysfunction in Washington, which I think the market discounts but it is there," says Rex Macey, chief investment officer at Wilmington Trust Investment Advisors, which manages $20 billion.


With the economic recovery four years old, earnings growth has fallen into the low single digits. Many investors fear third-quarter results could be soft. That would fuel worries about how stocks will handle eventual Fed stimulus cuts.

Until now, a lot of profit gains came from cost cutting. With companies now beginning slowly to hire and boost wages, future gains will depend on boosting sales, which has been hard to do.

"You do need corporate earnings to continue to improve, and that is becoming increasingly difficult without increases in revenue growth," Mr. Trennert says. He says analysts will be paying close attention to sales forecasts in postearnings conference calls.


September job-creation and unemployment data are due from the Labor Department Friday. Job creation hasn't been strong. Unemployment has been falling, mainly because people are giving up looking.

Jobs weakness was a big reason the Fed didn't trim its $85 billion in monthly bond purchases at its September meeting. The new numbers will influence its meeting Oct. 29 and 30.

Soft job-creation would make the Fed more likely to maintain stimulus; stronger numbers would make it more likely to cut, says Mr. Macey of Wilmington Trust.

Fed Meeting

The Fed threw markets into confusion with its September decision.

Many money managers thought Fed Chairman Ben Bernanke had telegraphed plans for a stimulus cut. Mr. Bernanke said economic softness and a sharp uptick in mortgage rates made the Fed wait.

Mr. Bernanke also has suggested that a stimulus cut could depend on resolving the debt and government-spending disputes.

All of this makes the October meeting very hard to predict. Investors don't welcome the cuts, but not knowing the timetable makes it harder to invest.

With all this confusion, the Dow Friday was only 2.7% off its Sept. 18 record. One might wonder why the market is doing so well.

Many money managers expect all this uncertainty to be resolved successfully. If there are hitches, they have concluded, the Fed will bend over backward to keep the economy out of recession.

With all this support, many expect stocks to recover from any October declines. Some are so confident, they welcome declines, considering them buying opportunities.

That could mean it would take really unsettling news, like a default, to make stocks fall hard.

"If we get some volatility as we deal with the threat of a government shutdown, we would think about buying, adding to equity exposures," Mr. Macey says. "What we care about as an owner of equities is earnings: Will the economy keep getting better, will profits be stronger, and we think they will."

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