Story updated Oct. 1.
The government shutdown everyone dreaded became reality as of midnight Monday, but that simply means the game is afoot for investors.
Anticipating the failure to compromise, the markets fell in Monday’s trading – the Dow Jones Industrial Average shed 128.57 points, or 0.84%, and the Standard & Poor’s 500 Index lost 10.20 points, or 0.6%.
Contrary to expectations, markets were up slightly on Tuesday as many investors clung to the hope that the two sides would soon find a way to break the impasse and end the government shutdown.
"People expect this will be relatively short-term, with the impact hopefully minimal, but the longer it goes on, the more pressure Washington will face," Robert Pavlik, chief market strategist at Banyan Partners LLC in New York, told Reuters.
"If this lasts longer than a few days, you'll really start to see volatility pick up."
House Republicans refused to back down in their attempt to attach a provision to either delay or defund Obamacare to a “continuing resolution” that would have funded government operations until Dec. 15.
Democrats were just as determined that Obamacare must stand untouched.
The next few days will determine just how big the market fireworks will be, although as we’ll see, an ugly week or two on Wall Street could have its benefits.
But even if the two parties in the House and the Senate somehow reach an agreement and engineer an escape from this self-made trap, the government shutdown threat will not be over.
That's because continuing resolutions only cover a few months, whether it's mid-December (as in the House version) or mid-November (as in the Senate version). Then it's right back to where we are now.
Then there's the looming fight over the debt ceiling, which has even deeper implications for the markets because it also holds the threat of a default.
Congress is close to its limit on borrowing and needs to raise the debt ceiling by Oct. 17. Otherwise the federal government won't be able to borrow any more money - a big problem when you borrow 40 cents of every dollar you spend.
The last debt ceiling fight in the spring and summer of 2011 also featured threats of a government shutdown, as well as a near-default that dinged the nation's credit rating, which lopped about 15% off both the S&P 500 index and the Dow Jones Industrial Average.
Given the potential for more -- and even more serious -- budget battles between now and the end of the year, investors need to make sure their portfolio is ready for whatever happens.
And strange as it may sound, it's not all bad...
How the Markets Will React to a Government Shutdown
Before we get to what investors should do in the event of a government shutdown, we need to talk about what to expect.
Most markets will react negatively to an actual government shutdown, of course, though not all:
- Stocks: Equities will go down. Most experts anticipate a drop of at least 5%.
- Bonds: Interest rates will rise while yields fall. During the budget battles of 2011, yields on 10-year Treasury notes fell from 3.18% on July 1 to 2.61% on Aug. 2, eventually dropping to 1.88% by December.
- U.S. Dollar: The U.S. currency will weaken if there's a government shutdown, but could be in serious trouble if the U.S. fails to raise the debt ceiling and actually defaults.
- Gold and Silver: Precious metals will rise as investors flee other investments for their favorite safe haven. The weaker dollar will also help push prices up.
- Commodities: Most commodities, such as oil, will rise on a weaker dollar.
All that said, investors also need to understand that at some point Washington will resolve its fiscal issues, at least to the point where the government is funded and functioning.
And that's where the opportunity arises...
Keep Emotions Out of the Equation
As hard as it may be to stand by and watch the markets go crazy, investors need to keep their heads and resist joining the stampede.
As stocks head south, for example, be ready to buy or add to favorites that had gotten a bit too pricey.
Precious metals and other commodities, on the other hand, will give back their gains after the budget antics in Washington end. Savvy investors will hold off and buy on that dip, rather than buying during the surge.
Past experience shows this strategy could pay off nicely.
Back in 1995-1996, Republicans instigated a government shutdown in a budget battle with President Bill Clinton.
During the weeks of the government shutdown, the S&P 500 lost 3.7%. But in the month after it ended, the index rose 10.6%. Investors who bought in the midst of the crisis were rewarded with a very tidy 11% to 14% short-term gain.
Not too shabby.
And it's a lesson well worth studying as the knuckleheads in Congress bumble their way through a government shutdowns and look ahead to even more damaging budget battles.
"Any market drawdown would be temporary in nature," Chris Hyzy, who helps oversee about $325 billion as chief investment officer of U.S. Trust, told Bloomberg. "Sentiment is still skittish across the board. We've seen the Polaroid photo before; we've gotten ourselves through it in a much more difficult time than we are today."
Note: Avoiding falling victim to the herd mentality at any time, not just when there's a government shutdown, is one of the tenets of the Money Map Method, a book prepared specially for subscribers of the Money Map Report. You can read an excerpt from this insightful book here...
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