BUNK 33
PRAY FOR BUDGET SURPLUSES
If you’ve turned your TV on in the last 20 years, you’ve heard pundits speak in dulcet tones about budget surpluses. According to them (as well as most media, investors—both amateur and professional—and almost everyone else), surpluses are the pinnacle of economic and market righteousness, whereas deficits are terrible. That drone has gotten louder in the last few years, in the US and abroad.
A surplus means the government collects more than it spends, and that’s morally and ethically responsible and good (allegedly). And because of all that responsibility, the economy should thrive and stocks rise. Conversely (according to this storyline), a deficit (meaning the government spends more than it takes in) is bad, and you don’t want to see any budget deficits if you can help it. And of course, bigger deficits are worse than smaller ones, but they all lead to more debt—which is reprehensible (see Bunk 45).

If Everyone Believes It, Ask If It’s True

Most folks believe this—uniformly. And when almost everyone you know believes something so dearly, you know that’s a great time to check if it’s true. Should you pray for surpluses? And will they bring great stock returns? How can we know? Simple: Through history, we’ve had big surpluses and big deficits before—many times. Just check when there have been big surpluses, and what stocks did after that—and vice versa. It’s easy—there’s massive free historical data on our nation’s budget and stock returns—and those of other countries too. Straightforward debunkery!
Figure 33.1 US Federal Budget Deficit as a Percentage of GDP
Source: Global Financial Data, Inc., Bureau of Economic Analysis as of 12/13/2009.
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Figure 33.1 shows US budget deficits and surpluses as a percentage of GDP going back to 1947. Showing it relative to the size of the economy is the right way to scale the size of the surplus or deficit. Above the horizontal line is a surplus and below a deficit. Peaks and troughs are noted—deficit and surplus peaks. Note we had a big surplus at the end of 1999, and what followed was a big bear market. However, we had a big deficit in 1982 and in 1992, both followed by huge bull markets. And of course, we had a massive deficit all during 2009—while stocks staged a historically massive surge. The surplus didn’t help, and the deficits didn’t hold stocks down.
Table 33.1 shows that through history, big surpluses didn’t lead to great returns, as most think. Surplus and deficit peaks are noted, and subsequent 12-, 24-, and 36-month S&P 500 returns. Following surplus peaks, stocks average -0.2 percent after 12 months and just 7.2 percent cumulatively after 3 years. Surpluses don’t necessarily help stocks—in fact, they may hurt. Contrast that to deficit peaks—stocks average 22.1 percent 12 months after deficit peaks. Cumulatively after three years, stocks average 35.7 percent—materially better than after surpluses. Ask yourself, honestly, which looks better? The surpluses? Or the deficits?
We can quibble about what’s happening when a surplus or deficit is being built up and why. But because a deficit represents the US government spending more than it takes in over a year, it adds to our federal debt, and folks are hardwired to think debt is terrible and more debt even worse (again, Bunk 45). But why? Think about a world with no debt. Most people can’t buy a house, purchase a car, or go to college. It’s a world where many folks wouldn’t start a new business. Why is that good?
But you know that personal debt, used responsibly (as the vast majority of people do) is fine and enhances life and possibly adds to earning potential. Think of all the folks who were groaning in 2008 and after—still in 2010—that banks won’t lend, or won’t lend enough. They understood that lending is a necessary and healthy economic growth driver. In my experience, those groaning the loudest that banks won’t make more loans are also those who complain most that we’re over-indebted. (Nearly every politician—globally—comes to mind.) Perverse! Can’t have it both ways.
Corporate debt you’re generally comfortable with. Firms regularly use debt wisely—to do research and development (everybody likes new, cool, inventive, and life-extending discoveries); build new plants; hire employees (everyone loves higher employment); expand; acquire competitors; and launch new product lines. Sure, some firms get into trouble, always have. Those firms’ stocks get hammered and the executives’ net worths crater. The CEO gets fired. These days, he (or she) may even get hauled in front of a congressional committee. Maybe the firm goes bankrupt. Using debt irresponsibly has real repercussions that most people and firms fear, expect, and want to avoid. Ignore media headlines designed to evoke emotion—overall, with some exceptions, most people and firms use debt responsibly.

Stupid Government Debt and Velocity

Sadly, our government often uses debt stupidly. When you borrow and spend, you borrow and spend normally. Our federal government borrows and spends on inefficiently run programs of dubious value—happens all the time. You know that. Fortunately, the money the government spends goes to one of three places—another government (foreign, state, local, etc.); an institution (whether for-profit or non-profit); or people. The governments that get the money a government spends often spend it stupidly again—on $300 hammers and airports with three daily flights to Washington, D.C., and nowhere else—but that money again goes to one of three places (mostly institutions and people).
And the institutions and people who get their hands on any of that money re-spend it normally—on payroll, new computers, lumber, electricity bills, insurance premiums, groceries, etc. And whoever receives those re-spent dollars spends them again, normally, and so on—and every spend benefits the economy. So, the economy is better off even when the government borrows and spends very stupidly, because the later spends average out to normal.
Table 33.1 S&P 500 Returns Following Deficit and Surplus Peaks—Not What You Think
Source: Global Financial Data, Inc., Bureau of Economic Analysis, S&P 500 price return, as of 12/31/2009.
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The rate at which money newly created—through a bank loan, for example—moves through our economy is called velocity. In America, when new money is created via a bank lending money to the US government, on average, that money gets spent about six times in the first 12 months. That’s six spends that wouldn’t happen otherwise. Five of those are normal and often one (the first one) is really stupid. But those five spends help stimulate the economy. And markets know that and love it, which is why, when deficits get huge and even peak, market returns going forward are fine. What you see is all that money flying around with some of it ending up directly in stocks and other parts of it ending up in higher profits for the companies that issue stock.
Which is also why stocks don’t do as well after big surpluses. In a surplus situation, the government takes in more than it spends and pays back its loans (reducing its debt), which shrinks the quantity of money relative to what it would be otherwise. And then those spends of the other five folks don’t happen and the economy isn’t as stimulated. Stocks somehow know that and don’t fare as well.
So I don’t fear deficits in the US. Nor in other major developed nations. I showed deficit and surplus high points and subsequent stock returns for the UK, Germany, and Japan in my 2006 book, The Only Three Questions That Count. The same thing was true—stock returns following deficit high points easily beat those following big surpluses. My guess is it applies pretty universally in all major developed nations.
You may not like government debt, but you shouldn’t react negatively to stocks when you see big budget deficits that cause more future debt. History is clear. Instead, react bullishly toward deficits. And if you do heavily fear or dislike government debt and think that might be enough to make you bearish on stocks, you might check out Bunk 45. But when it comes to stocks, what I actually fear is a surplus. You should too. History shows the aftermath of surpluses isn’t good for stocks. And that’s what counts.
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