Wall Street Traders: Wall Street traders brace for extended shutdown amid lofty valuations – News Air Insight

Ahead of the crucial earnings season, threats to the torrid US stock market rally are compounding. With no end in sight for the government shutdown, traders are gearing up for the aftermath as equity valuations are at eye-watering levels and the labour market shows signs of cooling.

Corporate America is set to start disclosing results next week and expectations are sky-high. The S&P 500 Index is trading at 23 times expected earnings, on par with the dot-com levels, so stocks are vulnerable to any disappointment in quarterly results. Meanwhile, investors are flying “nearly blind” with respect to key economic data as the impasse on federal funding in Washington has delayed reports, JonesTrading said.

The shutdown is a “sentiment downer for investors,” said Marshall Front, senior managing director at Mesirow Financial’s Front Barnett. “With a shutdown like this, you’re likely to see that become another factor in people’s decisions to either hold money on the side or maybe take profits before year-end.”

Front wouldn’t be surprised to see a 5% to 10% pullback in the S&P 500 this month given the combination of seasonal risk, shutdown uncertainty and the chance for risk-on sentiment to come back down to Earth.

Brian Mulberry, senior client portfolio manager at Zacks Investment Management, said he’s been trimming positions in some highly valued stocks, including Nvidia Corp., to re-allocate to names with lower valuations like Deere & Co. and Caterpillar Inc.

He’s not alone. Piper Sandler chief market technician Craig Johnson urged investors Wednesday to consider “trimming gains, especially on over-extended momentum stocks,” seeing potential for a 3% to 4% pullback after five months of gains.

The S&P 500 has, on average, been little changed through the last 20 shutdowns dating back to 1976, according to Truist Advisory Services Inc. However, when the 10% gain during the 2018 shutdown is excluded as an outlier, the average drop is 0.5%.Read More: Investors Shrug Off Government Shutdown Threat: Equity Insight

Locking in Profit

Along with the delay to non-farm payrolls on Friday, traders are also without a widely consulted report on futures trading, and statistics on oil and gas storage. Instead, they pored over other sources like private-sector payrolls data that showed a softening in the job market.

The shutdown creates “foggy” conditions for traders at a time when there’s a lot of tension over the Federal Reserve’s policy path, said Keith Lerner, chief investment officer and chief market strategist at Truist. So far, the market is still expecting the Fed to cut interest rates at least once more this year.

Market volatility is expected to spike the longer the shutdown drags out, especially if it were to delay the upcoming consumer price index report, according to the Bank of Nova Scotia. The latest read on inflation is supposed to be out on Oct. 15.

So far, investors have been ignoring the mounting risks, sending the S&P 500 to fresh records. The benchmark capped a six-day win streak Friday, ending the week 1.1% higher. Even the Cboe Volatility Index has held steady since Wednesday, when the political gridlock began.

Still, Goldman Sachs economists said “there are few good analogies” with the current shutdown, since “most prior shutdowns have involved broader budget negotiations, a shutdown of only some but not all agencies and/or a debt limit increase, which is not in play this time.”

Even the 2018 shutdown isn’t comparable to the current one given the last event occurred in the middle of a rate cutting cycle and valuations were much lower, said Mulberry.

Indeed, some options traders are expecting more volatile sessions ahead. And there are signs that investors are looking to lock in profits, with some willing to pay more to protect against a dramatic downturn in stocks before year-end.

There has been a “pretty significant demand for hedging” in recent weeks, though it’s not solely related to the government shutdown, said Robert Knopp, co-head of the S&P options desk at Optiver in Chicago. He added that most of the options trading “has to do with investors trying to pinpoint” when payrolls and inflation data will be released.

Three-month put skew, a measure of the relative cost of protection from stocks falling, has risen faster than other tenors, according to Mandy Xu, vice president and head of derivatives market intelligence at Cboe.

The attitude among investors appears to be: “You’ve had a good year, lock it in,” said Xu.