The Stock Market Braces for an Extended Shutdown Amid Lofty Valuations

The U.S. stock market’s powerful rally faces growing challenges as investors head into a pivotal earnings season. With the government shutdown showing no signs of ending, traders are bracing for turbulence amid lofty equity valuations and fresh evidence of a cooling labor market.

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Corporate earnings season kicks off next week, and expectations are running high. The S&P 500 is currently trading at roughly 23 times projected earnings—levels not seen since the dot-com boom making stocks particularly sensitive to any earnings misses or cautious guidance. At the same time, investors are “flying nearly blind,” according to JonesTrading, as key economic reports are being delayed due to Washington’s funding stalemate.

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“The shutdown is a psychological drag on investors,” said Marshall Front, senior managing director at Mesirow Financial’s Front Barnett. “It’s the kind of uncertainty that makes people hold onto cash or take some profits before the year wraps up.”

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Front added that he wouldn’t be surprised to see a 5% to 10% pullback in the S&P 500 this month, citing a mix of seasonal volatility, fiscal gridlock, and fading risk appetite as contributing factors.

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Other market strategists share a similar cautious stance. Brian Mulberry, senior client portfolio manager at Zacks Investment Management, said he has been reducing exposure to richly valued names like Nvidia Corp. and reallocating funds to more reasonably priced industrial giants such as Deere & Co. and Caterpillar Inc.

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Piper Sandler’s chief market technician Craig Johnson echoed this sentiment, advising investors to “trim gains, especially on overstretched momentum stocks.” He sees potential for a 3% to 4% pullback following the S&P 500’s five-month streak of advances.

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Historically, U.S. stocks have shown muted reactions during past shutdowns. Data from Truist Advisory Services Inc. indicates that across the last 20 shutdowns since 1976, the S&P 500 has been relatively unchanged on average. However, if the exceptional 10% rally during the 2018 shutdown is excluded, the typical performance drops by about 0.5%.

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With the shutdown delaying major reports like nonfarm payrolls, oil and gas inventory data, and futures positioning traders have been forced to rely on alternative sources. Private payrolls data this week hinted at a softening job market, fueling debate over whether the economy is losing momentum.

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Keith Lerner, chief investment officer and strategist at Truist, described current conditions as “foggy.” He noted that investors are already anxious about the Federal Reserve’s next move and that the lack of official data only amplifies that uncertainty. For now, markets are still pricing in at least one additional Fed rate cut this year.

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The Bank of Nova Scotia warned that if the shutdown drags on and delays the upcoming consumer price index report scheduled for October 15 market volatility could rise sharply. Despite these risks, investors have largely shrugged them off so far, with the S&P 500 closing at record highs last week after a six-day winning streak that lifted the index 1.1%. Even the Cboe Volatility Index, or VIX, has remained steady since the political stalemate began.

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Goldman Sachs economists pointed out that “few past shutdowns provide a clear comparison” to today’s situation. Unlike previous episodes, this one isn’t tied to broader budget negotiations or debt-limit debates. Similarly, the 2018 shutdown occurred during a rate-cutting cycle and at much lower valuation levels, making today’s environment distinct, Mulberry added.

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Still, options traders are positioning for choppier markets ahead. Demand for downside protection has risen as investors look to lock in profits after a strong year for equities. “There’s been pretty significant hedging activity recently,” said Robert Knopp, co-head of the S&P options desk at Optiver in Chicago. While some of that is linked to the shutdown, Knopp noted that traders are also trying to anticipate when key economic reports like payrolls and inflation data will finally be released.

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Mandy Xu, vice president and head of derivatives market intelligence at Cboe, observed that three-month put skew a gauge of how much investors are paying to hedge against stock declines has increased faster than other maturities.

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The prevailing sentiment, Xu added, seems to be: “You’ve had a good year now’s the time to lock it in.”

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As earnings season begins and the fiscal standoff lingers, Wall Street faces a critical test. With valuations stretched, data delayed, and sentiment increasingly fragile, even a small disappointment could be enough to trigger the kind of pullback cautious investors have been warning about.

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