By Ryan Vlastelica
NEW YORK (Reuters) - U.S. stock investors, hoping to leave politics aside to focus on fundamentals, aren't going to get their wish yet as lawmakers battle over raising the debt ceiling.
Proof that political uncertainty was holding down markets was seen on Thursday and Friday as the S&P 500 generated two days of strong gains in advance of the weekend.
Legislators will be busy negotiating raising the $16.7 trillion federal borrowing limit and reopening the federal government. If the borrowing cap is not increased by October 17, it could lead to a U.S. debt default.
The government has been partially shuttered since October 1. The shutdown has lasted longer than many expected, and while proposals from both President Barack Obama and congressional Republicans have been viewed as signs of progress, a final agreement remains elusive.
When not worrying about the government shutdown, investors will dive into the first busy week of third-quarter results, led by bellwethers General Electric Co
"If we see a deal over the weekend, the market will trade back to where it was before all this concern settled in, near all-time highs," said David Joy, chief market strategist at Ameriprise Financial in Boston. "Otherwise we'll probably fall back to 1,650, possibly further, depending on how rancorous the disagreement is."
INCREASE IN VOLATILITY
The S&P 500 <.SPX> is above its major moving averages, which could serve as support in the case of a market decline. The benchmark index is 0.9 percent above its 50-day moving average of 1,678.22, and 1.8 percent above its 100-day average of 1,662.53.
Many analysts have forecast increased volatility the longer the market goes without a deal. The CBOE Volatility index <.VIX> spiked this week above 20 for the first time since June. Trading in VIX futures suggested more concern about the near-term market trend as well.
Data showed investors were willing to pay more for protection against a slide in the S&P 500 now than three months down the road. On Wednesday, the spread between the VIX and 3-month VIX futures briefly hit its lowest since late 2011 at around negative 2.
That condition reversed on Thursday when the market rallied sharply, but traders remain on guard against another jolt of volatility if Washington politicians emerge from the weekend without any progress.
The indexes' weekly performance was mixed. Late in the session on Friday, the Dow Jones industrial average <.DJI> rose 0.5 percent, the S&P added 0.2 percent and the Nasdaq <.IXIC> fell 1.1 percent, pressured by selling in some of its best performers this year, including Netflix
While most analysts said a default on U.S. debt would be catastrophic for the economy, they also said it was highly unlikely that a deal would not be reached.
Ken Fisher, who oversees $49 billion at the Woodside, California-based Fisher Investments Inc, said there was a "maybe 0.0001 percent chance" the debt ceiling would be breached.
"People have been saying that things are different this time, but Washington is just a distraction for markets, simple as that," Fisher said. "If a default was possible, you would see bond prices fall through the floor. Eventually you have to stop listening to the people crying wolf."
Notably, investors in the short-term Treasury bill market are preparing in case of a missed or delayed payment. Yields on bonds maturing from late October through the end of 2013 are at elevated levels as investors shun those issues as a result of the default threat.
EARNINGS HEAT UP
Next week is a busy one for corporate earnings. Results and outlooks from banks may be the most important, as investors look for companies' comments on how the shutdown may affect growth and the impact of higher interest rates. Among the early indications, Wells Fargo
"The shutdown will impact earnings growth some, but I expect the negative effect will likely be small," said Fisher. "We're clearly still in the middle phases of a bull market."
S&P 500 companies are expected to post earnings growth of 4.2 percent in the quarter, down from the 8.5 percent rate that had been forecast on July 1, according to Thomson Reuters data. Of the 31 S&P components that have reported thus far, about 55 percent have topped expectations, below the historical average of 63 percent.
While some government-prepared economic data will be delayed next week because of the shutdown, including consumer prices and housing starts, those still scheduled include the New York Fed manufacturing survey and Philadelphia Fed survey, both for October.
Monday is Columbus Day and a federal holiday. Stock markets will be open but the U.S. government, of course, will remain shut.
(Additional reporting by Angela Moon and Rodrigo Campos; Editing by Kenneth Barry)