That may sound scary, but even that outcome doesn't necessarily translate into a slumping stock market, says Tobias Levkovich, an equity strategist at Citigroup. When President Bill Clinton and House Speaker Newt Gingrich clashed over the budget in late 1995 and early 1996, the market actually rallied, with the S&P 500 gaining about 4 percent over the course of the shutdown. That suggests that investors were focusing on other factors such as economic growth and earnings.
As the intensity of the debate around cuts and shutdowns picks up, investors shouldn't overreact. "We don't think it's a great idea to trade around the vicissitudes of Washington behavior," says Levkovich.
Defense is one area where the cuts will be felt acutely, and investors have responded accordingly. The Pentagon is preparing to slash $46 billion from its budget year, which runs to Sep. 30, Defense Secretary Leon Panetta told Congress on Wednesday.
Defense giants Lockheed Martin, Raytheon and General Dynamics have all slumped this year, while the broader market has rallied. Lockheed Martin, which makes fighter jets including the F-22 Raptor and F-35 Lightning, has fallen 4.5 percent this year to $88.12. General Dynamics, which builds ships for the navy has dropped 2.8 percent to $67.32.
Chris Bertelsen, chief investment officer at Global Financial Private Capital, says the slump is an opportunity for investors to pick up stocks at a good price and lock in high dividend income. Lockheed Martin, for example, pays a dividend of 5.3 percent on its stock, more than double the average rate of 2.1 percent in the S&P 500.
In any event, investors know full well that the most important, and politically sensitive, U.S. budget problem is far from resolved: controlling the runaway growth in spending by government entitlement programs like Medicare.
"What we need are entitlement cuts in the long run, rather than discretionary cuts in the short run." says JPMorgan's Kelly. "It's obvious."