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Budget Deficits Bullish for the Stock Market

As usual the talking heads in the media are constantly assaulting us with information on the budget deficits. The implication being that the fiscal position of the U.S. is bearish for the stock market. As usual nothing could be further from the truth.

Anyone who works with economic data should be able to know immediately that this could not be a negative. And of course, with a quick 30 minutes we have created a spreadsheet that shows the reality.

I took the CBO data (Congressional Budget Office) from 1968 to 2007 and ran the numbers. Over the entire 40 years the average return was approx 8%. The best years of budget surplus were 1999 and 2000. The top quintile of budget surplus years averaged a return of 1.6%.

The worst years for budget deficits were 1983 and 1985. The highest quintile of budget deficits over the 40 years averaged a return of 15.5%. How could this be? What could explain it?

This is the same issue we face with unemployment. Stock markets do well during periods of high unemployment and they can get killed with a great economy. Making money in investing is not just choosing the stock or the bond, but understanding the liquidity cycle.

All economies have business cycles. In a democracy the political process almost guarantees that during periods of recession the central bank is required to flood the financial markets with liquidity. Since the “real” economy doesn’t need all of the funds, financial markets rise. This rise in the stock market, bond market and usually the real estate market is how monetary policy is transmitted to the “real” economy.

Investing with the media can be deadly for your financial health.




Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.