Why Stock Markets Love Falling Budget Deficits

by | January 8, 2010 4:42 am

By Gary Alexander

The biggest investment cloud hanging over the market in 2010 seems to be the expanding federal budget deficit, which grew by $1.4 trillion in fiscal-2009 and now threatens to top that record this year.

But according to Ken Fisher — CEO of Fisher Investments, a Forbes columnist and one of the Forbes 400 — this turns out to be one of those “universal truths that everyone knows” that just isn’t true. In his 2007 book, The Only Three Questions That Count: Investing by Knowing What Others Don’t, Ken debunks this and several other “deficit myths.”

In his book, Ken demonstrates that historical times of balanced budgets were the worst times to invest in stocks, while times of record-high federal deficits were much better times to buy. I’ll get to his historical evidence in a minute, but first I’d like to take you even further back — to the only year when the federal budget was entirely paid off — 175 years ago this week.

Near the end of President Andrew Jackson’s eight years in office (1829-1836), the federal deficit reached zero. It was on January 8, 1835 that the U.S. debt was totally wiped out. But then came a cash crunch: Two years later on January 2, 1837 the New York Herald reported that interest rates (which had been 7% a year earlier) had risen by 2% or 3% per month. This credit crunch helped launch the Panic of 1837, which lasted several years, into the 1840s.

Of course, the causes of the Panic of 1837 go far beyond Jackson’s parsimonious policies, but the basic reason why budget surpluses are bad for the stock market is that there are only two ways to balance a budget — through higher tax collections or less spending (or a combination of both).

Higher taxes remove money from the private, more productive economy, while higher tariffs cause shortages or inflation on high-taxed imports. Also, as Keynes later showed, tight reins on federal spending remove any chance of “priming the pump” via government stimulus programs.

Now, let’s take this story down to current times.

Do Budget Surpluses Cause Market Crashes?

The only balanced federal budgets (a surplus of revenues over expenses) in the last 50 years were in 1969 and 1998 to 2001. Were those good times to invest or not? I think you know the answer: Late 1969 was not a good time to invest: The worst January since 1950 was January, 1970 (the Dow fell 7.6%). The 1970s delivered real losses for investors in either stocks or bonds.

Then, after the budget surpluses of 1998-2001, the market tanked disastrously in 2002. In the 2003 recovery, major tax cuts helped boost federal revenues and reduce the deficit from 2004 to 2007, reaching a low of just $161.5 billion in 2007. What happened next? The worst crash ever. Stocks peaked in October 2007 right after the government reported its lowest deficit since 2002.

Fisher charted the historical quarters (from 1947 to 2005) in which the federal deficit reached its highest percentage of GDP. As you can see, those were mostly great times to buy stocks:

* As percent of GDP; ** S&P 500 in the next 12 months and 36 months, respectively
Source: BEA (deficit): Global Financial Data (stocks)

After the five worst deficit quarters of the last 60 years, the stock market grew by an average 22.5% in the first year and +37.6% after three years. By contrast (below), the highest surpluses were followed by mediocre markets: Down 1.1% in the first year and +3.5% in three years:

This is not a very appetizing truth, but according to Ken Fisher’s analysis, budget surpluses seem to precipitate market crashes while high deficits seem to precede bull markets. Could that be true?

Markets Look Forward

Ken’s contrarian analysis of deficits is a refreshing way to topple old stereotypes. But I must add a rather long footnote to his dismal conclusion. In sum: Markets tend to rise when deficits are falling and peak when deficits are small, or a surplus begins. Then, markets decline until federal spending “turns a corner” and deficits start to shrink. Markets look forward: Sell when you see headlines of “balanced budgets forever,” and buy when pundits say that “budget deficits will grow for as far as the eye can see” (sound familiar?)

Going back to the 1830s, the market didn’t panic until May of 1837, after the brief budget surplus turned into a new deficit — namely, a new $10 million Treasury bond offering. It was smart to sell stocks on that first bond offering, but not before. The same would be true in modern times: Buy stocks when deficits are declining (like 1992 to 1999), then sell when the surplus begins to shrink (2000). Buy when the deficit is shrinking (2003 to 2007) then sell when deficits first rise (2008).

The market fell sharply from October 2007 to March 2009, while the budget deficit was rising just as sharply. However, the peak deficit months may already be behind us. The market looks forward. In fact, monthly budget deficits peaked in early 2009, just when the market bottomed:

* In millions of dollars; source: U.S. Treasury

* In millions of dollars; source: U.S. Treasury

So far, the peak deficits occurred in 2009’s first calendar quarter. Deficits are still too high, and they will be high for a long time, but their size may be declining, and that is good for the market. The market anticipates that a strong global recovery will lift tax receipts and lower the deficit.

At least that’s what I prefer to believe. Sorry, Ken. Most Americans feel, as I do, that high federal budget deficits are a form of grandchild abuse, saddling the yet-unborn with cripplingly high debts. It would be a sad conclusion, in my view, to say that stock markets love deficits.

However, if the deficit expands this year, the market might fall, so we should carefully watch the deficit trend this year.

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