Market correction or another bull market?

What if we could see where the overall market was heading?  Predictions abound and let’s face it, there’s a 50% chance of being correct.  This weekend’s Wall Street Journal (04/09/11) ran a story titled “Is the Market Overvalued?”  What’s the correct answer? Well it depends.  We have two financial heavyweights, on one side Robert Shiller of Yale saying stocks are expensive and on the other, David Bianco of Bank of America Merrill Lynch saying stocks are a bargain. 

Considering the economic and political turmoil of late I’ve been looking for a relatively simple correlation of data points relating market performance to government spending, and inflation.  Now I’m no economist but I know rising government spending as a percent of Gross Domestic Product or GDP will lead to rising debt and/or higher tax rates, affecting earnings, savings, consumer spending, and other forms of productive behavior. Additional government borrowing consumes capital that otherwise would be available for private investment. Upward trends in these metrics are not market friendly. On the flip side too little government spending is not good for the market.  The question is; is there a balance or even a correlation that ties into market performance?

The Data:
The graph below plots the S&P 500 adjusted for inflation, total government spending (federal, state and local) as a percentage of GDP and inflation starting at 1960.

There are a few interesting observations in the data.  In 1965 government spending as a percent of GDP was at the low (for the range shown) with little inflation. A year later the S&P (inflation adjusted) peaked, gaining an impressive 48% since 1960. 

During the next 17 years the spending as a percent of GDP trend reversed, trending up and peaked in 1982 along with higher inflation.  The result; the S&P lost 55%, not a good period for investors. 

The next period, 1982 to 1991, spending (percent of GDP) slowed and inflation trended to low single digits with the exception of a short term temporary spike in 1991.  The market continued its recovery from the trough it found itself in from 1982.  What is interesting is spending returned to a downtrend after 1991 and bottomed at 32.6% of GDP in 2000; a 22 year low.  The market soared 250% to new heights over this time frame giving meaning to the term “irrational exuberance” uttered by Alan Greenspan in 1996.

The Present:
Over the last few years government spending as a percent of GDP soared through the financial crisis and predictively the market responded negatively, even with inflation under control.  How the foundation was laid for the mortgage/financial debacle to occur is another topic. 

Where to from here:
The data suggests government spending (percent of GDP) is market neutral to bullish during down or flat trends in spending and bearish during any uptrend, even with inflation under control.  Higher inflation exacerbates any uptrend in spending pushing the markets lower. 

Much will depend on your faith in government at all levels to control spending.  Many state and local governments will be forced to cut spending because they are running huge deficits.  The federal government will tend to hold the line as it relates to GDP and possibly enact reductions.  I see overall spending flat to down over the next few years due mainly to state and local government reductions.  GDP should continue to recover if the economy improves helping push overall government spending as a percent of GDP down.  The major unknown is inflation.  An uptrend in inflation with no change in government spending as a percent of GDP will be bearish although the data appears to associate inflation increases with increases in spending with the present being the exception although that could correct itself going forward.

I’m not on the bearish side or in Robert Shillers camp and may not be as bullish as David Bianco but believe the market will trend up from here over time.  It will be anything but smooth sailing accompanied by more volatility than the decades past.  Going forward the spending trend will be down which is positive for the market longer term.  If the reader feels government spending as a percent of GDP will continue to rise and/or inflation looms large then the question would be whether to be in the market at all.

A final observation;  I’d say that spending as a percent of GDP and the economy are mutually dependent, in other words as government at all levels expand or contracts will impact on the economy to some degree directly impacting the markets.  Also market bubbles could drive spending decisions as did the mortgage crisis; fortunately events of this magnitude are rare events. The data shows spending at record levels and there appears to be agreement on all sides politically to rein it in, another reason to expect the spending line in the above graph to trend down which is positive for the markets.

My approach:
Personally I’ve become more cautious (read conservative) over the last few years, demanding higher discounts to fair value and lean toward companies with dividends. Stocks tracked are found here, none of which at the time of this writing trade at a high enough discount to fair value (by my standards) to either add to or increase existing positions.

Data sources:


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