Late last night, the House and Senate passed legislation to
end the government shutdown and lift the debt limit. Stocks
rallied 1% yesterday in anticipation of the news. And all major
U.S. indices are trading slightly higher than their price on
October 1 when the government shutdown began.
This latest legislation from Washington will kick the can down
the road until 2014, when there will be another battle over
government spending and debt limits.
But with all the attention on the ineffectiveness of the U.S.
government, investors have been ignoring something far more
important to the long-term performance of stocks.
Corporate earnings growth is what causes stocks to rise over
the long term. And investors shouldn't get too consumed
with the spectator sport of Washington politics. Third
quarter earnings season kicked off last week with little
Looking back, we know that previous government showdowns over
debt and spending have done little to derail stock
Seven and a half months ago, the March 1 sequestration
deadline arrived without a deal. While the sequester didn't
receive the same attention as today's debt deadline or the fiscal
cliff, some thought the absence of a deal might have a negative
impact on the market. Since then, stocks have made new highs
month after month.
In reality, few companies have been affected by sequestration
cuts. Only a handful of them reported any negative sequester
impact in their second-quarter earnings. Many of the companies
traded on U.S. exchanges are multinational entities with global
footprints. Thus, their earnings are driven largely by global
economic growth. In the grand scheme of things, $85 billion in
government spending cuts represents little more than a speed
Similarly, the government shutdown isn't likely to put much of
a dent in corporate earnings growth. The impact of the shutdown
on the 800,000 federal employees on furlough is very real.
Thankfully, they'll now be back at work for the time being.
Fortunately for many public companies, American spending is
but one slice of a much larger earnings pie. About 40% of S&P
500 corporate profits come from global sources. Europe's
sovereign debt problems have weighed heavily on profits the last
couple years. So has slowing growth in China and India.
Despite all of it, earnings at S&P 500 companies have
grown year over year every quarter since mid-2009.
The third quarter is expected to be no different. Analysts
project a 4% increase in profits for the S&P 500 companies in
the third quarter. Recently, corporate earnings have exceeded
expectations by an average of 4%. Should that happen again, it
would result in the strongest earnings growth in more than a
What's remarkable is that stocks have risen sharply in recent
quarters in spite of falling EPS growth. Earnings growth has
actually been on steady decline since 2010. Nevertheless, stocks
have risen 45% in the last three years. Acceleration in earnings
growth this quarter may not push stocks even higher. But it could
be enough to offset effects of the government shutdown, the debt
ceiling debacle and other headwinds.
Even after last night's last-minute resolution, I realize that
our government is a complete mess. Federal employees have been
out of work for 15 days while Congress twiddles its thumbs. And
there seems to be a debt deadline or a fiscal cliff or
sequestration cuts every few months.
Those events create volatility and fear. But the effects are
mostly short term. In the long term, corporate earnings are a
more important for determining stock prices.