Is the Government Shutdown Bullish for Stocks?

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

If today's performance is anything to go by, you might be tempted to answer "yes" to the headline. The S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) had a very decent "Shutdown Day 1," gaining 0.8% and 0.4%, respectively.

However, that does not constitute supporting evidence under even the flimsiest standards. Consider, for example, that stocks declined in seven of September's last eight trading days, for an aggregate 2.4% loss during that period. It's pretty clear those losses were partially related to the threat of an imminent shutdown, so that today's gains could simply be investors adjusting for what they now perceive was a negative overreaction earlier.

If so, the same process seeped into the volatility market, as the CBOE Volatility Index (VOLATILITYINDICES: ^VIX  ) fell back 6.4% today, to close at 15.54. The VIX, Wall Street's "fear index," is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.

Some commentators were willing to run with spurious observations to justify a bullish interpretation, as this excerpt from the Reuters Counterparties blog, edited by Felix Salmon and Ryan McCarthy:

Markets seem to believe that this shutdown is going to play itself out as its predecessors did, [Bloomberg's] Matthew Klein writes. And that's bullish: since 1976, "the S&P 500 has risen 11% on average in the 12 months following past government shutdowns, according to data compiled by Bloomberg.

That's bullish? Really? Without any attempt to establish a causal link between a government shutdown and 12-month stock returns? The best you can say is that the former has a small but potentially significant impact on one quarter's GDP. Furthermore, the bigger effect on stocks would probably stem from the impact on investor sentiment/ risk aversion, particularly during the late 1970s, after four consecutive government shutdowns lasting more than 10 days, beginning on September 30 in 1976, 1977, 1978, and 1979 (although one could make an argument that the market became inured to the problem after the first couple).

Good luck trying to break out those effects from those deriving from starting valuation, earnings increases, and changes in anticipated earnings during the following 12 months and so on. Furthermore, it's not even clear that 12-month stock returns accurately reflect those factors, which are direct inputs for calculating stock values!

Bottom line: I'd be very surprised if government shutdowns have any measurable impact on long-term stock returns -- the only returns investors ought to be concerned with. However, I think a sovereign default by the U.S. on its obligations could wreck stock returns over an extended period of time. That's one potential outcome of government dysfunction that investors can legitimately worry about.

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