Much is being discussed in regards to the current government shutdown and soon to arrive debt ceiling.  I want to provide my thoughts on these issues and more importantly I want to address how it affects one’s long term planning.  I know I am not expected to speak in certainties about what will happen in the coming weeks.  We live in a world of probabilities, not certainties, and so I will speak from that perspective.

What of this government shutdown and debt ceiling?

In regards to the government shutdown the phrase that I think may sum it up best is ‘the storm before the calm.’   The storm refers to the risk associated with DC wranglings.  I think most of this risk is headline risk.   It is the risk that the news headlines will lead investors to change their approach due to our short term fortunes.   The economic impact would be a small dent to fourth quarter growth.

Of greater concern is the significant risk associated with the debt ceiling, which we will hit in mid-October unless Congress and the President agree on an increase.  The probability of no agreement is small, but this could be quite disruptive and cause economic problems to a greater degree.

We have had 16 ‘government shutdowns’ since 1977.   The longest in 1995 lasting 21 days, and the shortest being one day in 1982, 1987, and 1988.  In the month prior to the Dec 1995 – Jan 1996 21 day shutdown, the S&P 500 lost -.2% and in the four weeks after the shutdown it rose 3.1%.  During this current government shutdown, approximately 80% of the government is still functioning.  As far as the debt ceiling is concerned, we have never had an impasse where the debt ceiling wasn’t raised and default occurred.

The calm I refer to is what has been occurring in the economy since July 2009; a sustained, though slow, recovery with a return of US manufacturing opportunities.

A broader look away from DC in October.

If we step away from DC and away from the last month we see a picture that is of note.  In July 2009, we ended our last recession.  Since WWII, each recession to recession business cycle has averaged 5 years.  This means that in July of this year we were at the 4 year mark and the averages would tell us that in July 2014, a recession will arrive.  Since I am speaking about averages, some have been shorter and some longer, but let’s go with the July 2014 date for this discussion.

There are two key indicators of post WWII recessions; first, corporate profits deteriorate and second, short term interest rates rise.  Profits are currently still historically high and Federal Reserve actions suggest no such short term interest rate rise is close.

What is different in our current market cycle is that growth, albeit slow, has been from natural demand.  In the 80’s and 90’s growth was credit driven.  Businesses took loans to expand their business and looked to get a return on the debt that fueled growth.  Consumers did the same thing by refinancing their homes and maxing out credit cards.  Since businesses have not used debt to expand, this has freed up spending power and impacted profits.

So whereas the 80’s and 90’s gave us 4% debt fueled growth, the last 4 years has given us 2% natural growth.  Will this slower growth ‘stretch out’ the business cycle beyond the 5 year average?  I don’t know, but there are 5 things that suggest it very well could.   First is a manufacturing renaissance in the US.  Second, energy costs have decreased in the US.  Third, consumers have been reluctant to spend and we are now entering a replacement cycle which will drive spending.  Fourth, as noted above companies and consumers have lowered their debt.  And finally, with rates where they are there is a low cost of capital for those looking to borrow.

How does this economic outlook impact the market?

Many people look at the numbers that the S&P 500 Index and the Dow Jones Index are hitting and suggest we are at an all-time high.  And when they hear ‘all time high’ they think they need to act…and by act I mean ‘get out’.  But, a look at some fundamentals underneath the point level may suggest something different.

March of 2000 and October 2007 were the last two times we were near the same S&P 500 index levels as we are now.  The earnings per share for companies was $54 in 2000 and $89 in 2007.  Today it is around $100.  This speaks to the profit levels of companies being better.  In 2000 the amount of debt companies had in relation to assets was 37%; in 2007 it was 32%.  Today, it is closer to 24%. This suggests that companies have less debt to pay on.  Price to earnings is the ratio between a current stock price and how much the company is earning in income for each share of stock.  The higher the number, the more people are willing to pay for a level of earnings.  Paying more means an investor thinks the value in the future will be higher.  In 2000 the P/E was 28x; in 2007 it was 24x; and currently it is approximately 14.3x.  With a historic average P/E 15x this tells us that stocks are not extremely overpriced.  So, whereas the current point level of the S&P 500 index represents a market high, the underlying data suggests something different.

Summary

It is probable that near term dysfunction in DC will lead to an increase in volatility.   Frankly, volatility has been unusually low lately and I think it is likely it will pick up and be around for a while.   If we do have this volatility, for many it can be seen as a buying opportunity.

If we do enter a recession before or in mid-2014, should we be alarmed?  Should we panic?  Should we become fearful?  The answer to all in my opinion is no.  The reason for this is that recession is an expected part of the business cycle.  Certainly government policy plays a part in the vibrancy of an economy and would affect how a recession begins and ends, but again, the certainty of a worst case scenario is not currently high.

I am always interpreting what I see coming down the road, and new factors can change any outlook, but currently I think the highest probability is for a slow growth economy that is sustainable in spite of bouts of volatility sparked by in part by our federal politicians.

Author: David Jeter, CFP®, Allegheny Financial Group, October 2013


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The above comments are provided for discussion purposes only and are not meant to be an offer of any specific investment.