Last week, I said that Wall Street’s focus will be on the economy in the weeks to come. On cue, the economic data stunk badly enough to draw everyone’s attention. Second-quarter GDP growth was modest, and estimated first-quarter growth was revised down to a fraction of a percentage point. The ISM chimed in with a manufacturing survey that suggested that the third quarter is not off to a good start and that the short-term future may not be any better.
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.
Charles Rotblut, CFA is a Vice President with the and editor of the AAII Journal.