By Caroline Valetkevitch
NEW YORK (Reuters) - U.S. stocks are likely to face another week of rising turbulence as efforts to settle the budget dispute in Washington drag on, leaving investors worried about the more critical issue of raising the U.S. debt ceiling.
The budget impasse has led to a partial U.S. government shutdown for the past four days, already longer than many investors had expected.
While stocks ended higher on Friday, the S&P 500 posted a loss for the week and the CBOE Volatility index - the market's fear index - rose to 16.89, up from 13.12 on September 20. The index is still at relatively low levels, but options-market trading suggests investors are starting to guard against increased volatility.
The larger issue for investors is that efforts to solve the budget problem could become entangled with the issue of raising the debt limit. If the $16.7 trillion borrowing cap is not increased, it could lead to a possible U.S. default.
"It's not likely, but it's certainly a remote possibility. That is the big fear, because that's an event that has not been discounted by the market," said Quincy Krosby, market strategist at Prudential Financial in Hartford, Connecticut. "And it's not just a domestic event; it's a global event."
The Treasury has said the United States will exhaust its borrowing authority no later than October 17. Republican House Speaker John Boehner told his party colleagues he would work to avoid a U.S. debt default, according to reports, helping stocks on Friday. But there is little hard evidence that the stand-off is nearing a resolution.
The dilemma has stopped the market's climb that took it to a record close September 18, when the Federal Reserve decided against trimming its stimulus plan. The S&P 500 has lost 2 percent since that date.
The utilities sector, with its high-yielding dividend payers, has lost the most of any S&P 500 sector since the shutdown's start. However, real estate, consumer and professional services and capital goods have also suffered, according to Bespoke Investment Group.
Real estate as an industry group, which depends on interest rates that could rise in the event of a default, is down 0.8 percent. Utilities have lost 0.7 percent. Shares of home builder DR Horton are down 4.6 percent since Monday's close.
Shares of defense contractor Lockheed Martin are down 4 percent. Defense stocks are vulnerable because they depend on contract work from the government for revenue.
Part of the S&P's decline since the Fed announcement has also been on concern the economy is weaker than many investors had thought, with the Fed having lowering its economic forecasts for both 2013 and 2014.
One fear is the U.S. government shutdown could threaten the fragile economic recovery, and some analysts have even suggested it could push the U.S. economy back into recession.
"With the government shutdown and all of the uncertainty around it, we're pretty sure there will be additional negative impact on economic growth," in particular on consumer spending, said Natalie Trunow, chief investment officer of equities at Calvert Investment Management, which has about $13 billion in assets.
She said the market could see further losses in the short run. "We are in a good place in year-to-date returns, so it makes it easy for investors to take some profits off the table and step back and watch this unfold." The S&P 500 is up 18.5 percent since the end of 2012.
Making matters worse, the shutdown has meant the delay of the release of key government data, like the U.S. monthly jobs report, which was supposed to come out on Friday.
That's left investors to make decisions without crucial data to guide them and made it more difficult for them to gauge what may happen to the Fed's monetary policy.
Next week, data from independent providers including the Thomson Reuters/University of Michigan survey of consumer sentiment are still expected, in addition to minutes from the last Fed meeting.
Also, investors will see the first of third-quarter earnings from top S&P 500 companies next week, including results from JPMorgan Chase and Wells Fargo late in the week.
The forecast for third-quarter earnings has come down sharply in recent weeks - growth now is expected at just 4.5 percent - but financials are expected to lead S&P 500 profit growth for the quarter, with a gain of 9.5 percent, according to Thomson Reuters data.
Results from Alcoa are due next week as well.
While the VIX is still low by historical standards and compared to what it was in 2011 during another debt ceiling debate, it appears likely to drift higher from here, according to Randy Frederick, managing director of active trading and derivatives for Charles Schwab in Austin, Texas.
"I would say the upside maximum is the high 20s, close to 30," he said. The VIX traded as high as 48 in the summer of 2011.
Technically, investors have also been eyeing a significant break below the 50-day moving average on the S&P 500 as a sign of more weakness. The index closed below that level on Thursday but rebounded to trade modestly above it on Friday. The moving average was at about 1,679 on Friday.
If that breaks, "1,630 would be the next hard stop," Frederick said.
(Reporting by Caroline Valetkevitch; Editing by Leslie Gevirtz)