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We Have a Debt Deal

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 fanfare. 

Looking back, we know that previous government showdowns over debt and spending have done little to derail stock performance.

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 bump.

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 year.

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.