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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. Back in April, the Wall Street Journal ran a story titled "Is the Market Overvalued?" We had 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.

So who is right? It’s too early to tell, but looking at the S&P since April Robert Shiller is off to a good start.
ECON_SPchart.gif

Robert Shiller’s case is getting help from the financial crisis in Europe which started with Greece and has now spread to the “too big to fail” Italy. The crisis will engulf more countries if the political will to find solutions falls short.

Things are not much better in the US. The political will to rein in the debt and spending has yet to surface. The following debt projection was taken from data provided by the Office of Management and Budget in the FY2012 report.
ECON_GrossFedDebt

The super committee failed to come to an agreement to cut $1.2 trillion of spending over ten years; a trivial amount when compared to the graph above. Some would argue this debt forecast is a best case scenario given today’s environment.

The CBO issued an outlook in June and listed the following impact of rising debt. (Emphasis mine)

Rising debt would increasingly restrict policymakers' ability to use tax and spending policies to respond to unexpected challenges, such as economic downturns or financial crises. As a result, the effects of such developments on the economy and people's well-being could be worse.

Growing debt also would increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government's ability to manage its budget and the government would thereby lose its ability to borrow at affordable rates. Such a crisis would confront policymakers with extremely difficult choices. To restore investors' confidence, policymakers would probably need to enact spending cuts or tax increases more drastic and painful than those that would have been necessary had the adjustments come sooner.

Fitch Ratings gave the United States two years to come up with a plan to reduce the debt or risk a downgrade of its AAA rating and on 11/28 revised to negative from stable the outlook on the U.S. credit rating.

The next graph for M1 is from the Federal Reserve Bank of St. Louis:

click to enlarge
ECON_M1

What is disconcerting about this graph? The trend is going vertical. The government money printing machine from the quantitative easing (QE) policies is alive and well. The question is, given the debt, spending and political gridlock, will large amounts of debt be monetized and/or additional QE policies accelerating the money growth be implemented? The danger here is an increase in the money supply could have an inflationary effect. There is a time lag between money growth and inflation and to date it appears to be manageable. If there is a lag, what is it and can the Fed react quick enough to manage it?

How does this affect the market?

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.
Econ_Chart

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 (projected to exceed $26 trillion in 10 years) 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. We’ll apply the past to project a bull and bear case.

Bear Case:

Government spending cannot be brought under control due to political gridlock and growth in spending continues to outpace GDP growth. Entitlement programs and interest payments continue to grow as a percentage of expenditures turning the warnings by the CBO listed above into reality. The Fed continues to expand the money supply with QE3, 4, etc. reaching a tipping point and fueling inflation. The best match for this scenario is 1965 to 1982 as labeled above. The conditions were different but the pattern is similar. Spending outpaced GDP growth rising from 28% to over 35% of GDP accompanied by rampant inflation. The result; the S&P lost 55%, not a good period for investors. If this is the long term case the start would be 2007 with accelerating inflation to follow.

Bull Case:

The political parties agree on a way forward sometime in 2013 to tackle the debt and spending. Spending as a percent of GDP levels off with hopes of a downtrend if increases can be kept below GDP growth rates. The Fed is able to manage inflation.

The best match for this scenario is 1982 to 1994. Yearly returns over this period were approximately 8.3%. If this is the long term case it started in 2009.

Where to from here:

That’s the trillion dollar question. Much will depend on your faith in government at all levels to control spending and debt. 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. GDP should continue to grow if the economy improves helping push overall government spending as a percent of GDP down. The major unknown is inflation. An uptrend in inflation will be bearish.

No one knows what the tipping point is regarding debt or spending as a percentage of GDP. Will we trigger it in 2013, 2021, if we continue on the current path? The bull case is contingent on more reasonable minds coming together after the elections. Yes, I know; a tall order.

Even though we have faith in reasonable minds prevailing, we are proceeding with caution. We prefer dividend paying companies in times of economic uncertainty, demand higher discounts to fair value, and maintain a cash cushion. This assumes the long term bear case is avoided.

Below is a sampling of dividend yielding tech companies we’ve written about on Seeking Alpha. Microsoft (MSFT) and Intel (INTC) are large cap stocks with good track records of generating strong cash flows and earnings and low debt to equity ratios. Telular (WRLS) is a small cap stock whose history for generating cash and earnings is more recent since new management was installed around 2008 and has no long term debt.

Stock

Updated fair value

Date first Published I=SA instablog

Publish closing price

Recent Price

Dividend Yield

Article Link

(NASDAQ:MSFT)

$32

9/24/2010 (NYSE:I)

$24.32

$24.85

3.22%

Link

(NASDAQ:WRLS)

$9.3

8/1/2010 (I)

$2.48

$7.09

6.21%

Link

(NASDAQ:INTC)

$30

4/6/2011

$19.79

$23.58

3.56%

Link

Other Data sources:

http://www.multpl.com/

http://usgovernmentspending.com/

Source: A Bull And Bear Case For The Market