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Debt ceiling default could send stocks into bear market: Strategist

CFRA Research Chief Investment Strategist Sam Stovall joins Yahoo Finance Live to discuss how the debt ceiling default may impact the stock market, the 2011 debt ceiling crisis, and the tech sector.

Video transcript

Stocks moving lower today after President Biden's meeting with House Speaker, Kevin McCarthy did not make much progress, it doesn't seem, on the debt ceiling negotiations. McCarthy, though, did announce that staff meetings are going to continue, and he does expect to speak with President Biden every day until a deal is done.

We want to bring in Sam Stovall, CFRA Research chief investment strategist. Sam, it's great to see you here. So some losses in the markets today. But up until this point, and really largely speaking, the market has been very resilient. Why do you think that is, and what biggest lessons do you think we need to learn from 2011 in terms of the volatility that we could see play out in the market?

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SAM STOVALL: Hey, Shawna, good to talk to you again. Well, I think that most people on Wall Street think that cooler minds will prevail. We've had 20 government shutdowns since 1976, and the market basically yawned before, during, and after those shutdowns. This obviously is of greater concern should there be a debt crisis and certainly a debt default. But again, I think people are not expecting that.

In terms of revenues, we've got at least three times the revenues to cover the interest expenses. So 14th Amendment basically says, no, you've got to cover that. You could end up causing problems with other payments from the government, but we probably would not end up with a debt default.

But should the worst happen, history then tells us, watch out, because we could enter into, or close to, a new bear market with the October low being taken out. Because back in 2011, the S&P fell 19 and 1/2%, all sizes, styles, sectors, and 97% of subindustries fell in price with only gold, restaurants, and electric utilities being in positive territory.

- Sam we've heard the comparison to 2011 over and over. From a market perspective though, is that where we are right now, or is there a sense that things are a little more urgent this time around?

SAM STOVALL: Well, I mean, I think that there was the first time that we had the US government debt be downgraded, it ended up being a near bear market. I think, certainly, what is occurring now is, of a challenge as well because we are in a bear market environment right now.

Back in 2011, we had been emerging from that mega meltdown of the financial crisis. So we were in a bull market mode back then, giving back much of those gains. Here, we're still grinding our wheels in a bear market environment, but within 4 percentage points of a new bull market. So yes, there is a lot to give up this time around.

- Sam, is there much upside potential if we do get an agreement, or is much of that already priced into the markets in terms of that catalyst?

SAM STOVALL: No, I think just take a look at what happened last week, when we had the growing optimism that there would be some sort of a compromise. The flip side took place, meaning that we ended up with all sizes, styles, and 7 of 11 sectors in positive territory. Best performers were communication services, consumer discretionary, and tech, and investors were rotating away from the safe havens of staples, health care, utilities. So I think what we saw week-to-date through last Thursday was a very good idea of what we will get when a compromise eventually arrives.

- Sam, let's talk about Fed policy here. You say CFRA's base case here right now is that the Fed has ended its rate hiking cycle. We heard from Minneapolis Fed President, Neel Kashkari, yesterday, saying that there could be a pause but that doesn't mean another hike isn't off the table here. Does that put you pretty much in a holding pattern?

SAM STOVALL: Yeah. In a sense, it does. What would happen is basically having a skip situation where you don't do anything at the June meeting, but then maybe you raise rates at the next meeting. Our belief is that they're probably not going to be doing something like that because the implication is, to the marketplace, that they're not really sure what they're doing.

So I think that because of the reminder that they don't want to make the mistakes of the 1970s, because the data has come in stickier and because of all this Fed speak, there's probably a growing likelihood that we will see an additional rate hike in June. And as Jared was mentioning before, we usually have a pause period. But on average, that pause lasts nine months. And in that nine month period, the S&P has gained an average of 13%, rising in five of six observations since the late 1980s.

- Sam what about the odds of a cut before year end? Where do you stand on that? What do you think the Fed needs to see in order to do it?

SAM STOVALL: I think it needs to see a lot of problems, if it were to do it this year. Our expectation is that they're likely to cut interest rates in 2024 but not sooner. Again, because of the potential flip flopping that took place in the late '70s that they don't want to replicate. So I think that they are either on pause or will at the end of June. And then they're going to wait until, maybe, even the second quarter of next year before they start to cut rates, which will add to the volatility in the market during this traditionally seasonally challenged period.

- So let's talk about positioning in the face of that. You've highlighted specifically the tech sector, saying in a period of rising risk of recession, investors will lean on the group with growth potentials. Feels like tech is getting back in favor again right now, but what are some of the names-- what are some of the spaces within the tech sector that you like right now?

SAM STOVALL: Well. yes, we do like the tech area. Our belief is that sector rotation goes from first to worst, meaning the better performers in a down market tend to be the underperformers in the subsequent year, and tech was one of the worst performers so they tend to bounce back in that subsequent positive year. Those groups that have the highest CFRA stars rankings are application software, IT consulting, semiconductor equipment, systems software, and hardware. So a lot of these big names are in that group, but also looking for a resurgence in some of the semiconductor names as well.

- Sam, what about valuations though? Because when you compare it to history, it does suggest that valuations are stretched at this point, when it comes to tech.

SAM STOVALL: Well, not by much. I mean, when you look back to the 19-- look back to 2000, a lot of people thought tech was cheap, trading at 60 times forward earnings. Right now, the tech sector is trading at PE of about 22 times forward, which is basically about a 17% premium, but that compares with an 11% premium for the S&P 500. So on a relative basis, tech is actually trading at a single digit premium.

So I think that we could end up digesting some of the recent gains. We had the RSI above 70, full stochastic above 94, so I think, possibly, we're likely to digest some of these gains. But our belief is that for the coming 6 to 12 months, tech will still be a good place to be.

- All right, Sam Stovall, CFRA chief investment strategist. Thanks so much.