9-29-13 8:05 AM EDT | Email Article

By Wallace Witkowski, MarketWatch


SAN FRANCISCO (MarketWatch) -- Investors will need to fasten their seat belts in the coming week because whether or not the government shuts down Tuesday, the process is going to be bumpy.


Markets have already been responding to the political posturing. In the past week, stocks posted their first weekly drop since August, with the Dow Jones Industrial Average (DJI) and the S&P 500 Index (SPX) closing down 1.3% and 1.1%, respectively. The Nasdaq Composite Index (RIXF) managed to squeak by with a 0.2% gain.


On Friday, President Barack Obama urged House Republicans to avoid a government shutdown, stressing that even the threat was dragging on the economy. Earlier in the day, the Senate voted 54-to-44 on a measure to keep the government funded until Nov. 15 without provisions to defund Obama's health-care law that had passed in the House earlier.


"Right now, we're just going through this kabuki dance before midnight Monday because the government could shut down Tuesday," said Phil Orlando, chief equity market strategist at Federated Investors.


How low can stocks go?


Expect the S&P 500, which closed at 1,691.75 on Friday, to slide between the range of 1,600 and 1,650 over the next month -- a drop of 2.5% to 5.5% -- depending on how ugly things get in D.C., Orlando said. The 1,600 limit of the range becomes likely if there hasn't been any debt-ceiling resolution by Oct. 17, when Treasury Secretary Jacob Lew said the U.S. will be dangerously low on cash to pay its bills.


In comparison, the last time there was a government shutdown was Dec. 13, 1995 to Jan. 10, 1996, and the S&P 500 dropped 3.7% over that period, only to snap back up 10.6% by mid-February, according to a recent note by S&P Capital IQ.


Read: Fret the debt ceiling, not shutdown-- in charts


Sectors that have been pushed up lately from a valuations perspective will likely be the most vulnerable to a government shutdown, Orlando said, citing examples such as consumer discretionary, finance, tech, industrials and energy.


A shutdown would hit stocks during an already hobbled economic recovery, Orlando noted. Over the last nine recessions, GDP growth has averaged about 4.4% four years after the recession, compared with the current 2.5%. Given the logic that a deeper recession should have a bigger bounce back, Orlando said gridlock over fiscal policy has sapped much of the recovery's strength, referencing a speech New York Fed President Dudley gave earlier in the year.


Dudley said that the government's biggest policy mistakes, raising tax rates, the sequester, and the Affordable Care Act -- would impede GDP by about 1.75%. Coincidentally, that accounts for much of the deficiency from the average, Orlando noted.


Convinced a shutdown's inevitable? Follow the [lack of] money.


If you're convinced that the shutdown is going down, then you might want to give those government-dependent stocks in your portfolio a second look, said Frank Fantozzi, chief executive of Planned Financial Services in Cleveland, Ohio. Otherwise, stay the course and deal with the choppiness that's going to come out of negotiations going down to the wire.


Fantozzi is more concerned about collateral effects of the Fed not tapering in September, calling the decision not to start easing off asset purchases a "very bad signal."


"It's a self-fulfilling prophecy," Fantozzi said. "The Fed comes in and says the economy is not healthy. Well, if I'm a business owner, should I be hiring and spending?"


Speaking of the economy, there's the question of what happens to economic reports -- basically, a crucial link in gauging the pace of the economic recovery -- if the government shuts down. For instance, the Friday jobs report would likely get delayed.


If you're banking on the government shutting down for any appreciable period of time, Goldman Sachs advised in a recent note to start buying puts on some overlooked stocks with high government exposure as a hedge against the shutdown. Companies deriving more than 20% of their revenue from the government start appearing on the firm's radar.


Some of the companies most dependent on government for revenue are Harris Corp. (HRS) with 80% of revenue government-derived; Granite Construction Inc. (GVA) with 58%; Flir Systems Inc. (FLIR) with 54%; and Waste Management Inc. (WM) and Republic Services Inc. (RSG) both with 50%, according to Goldman Sachs.


Barclays analysts told investors to expect volatility with a mild negative bias against stocks until the risks of a government shutdown and debt-ceiling default clear, according to a recent note. Even if nothing happens, meaning the posturing ends up being posturing and the 11th hour deal is struck, the posturing itself is beginning to wear on markets.


Barclays said "the perpetual conflict and political discord of recent years has led to increased uncertainty, sizeable fiscal drags in the resolution (eg, sequestration), and temporary market disruptions. In other words, recent experience tells us the risk need not be fully realized in order to affect financial markets; walking close enough to the edge is sufficient."

-Wallace Witkowski; 415-439-6400; AskNewswires@dowjones.com


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(END) Dow Jones Newswires

09-29-13 0805ET

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