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Author: yodaorange Big red star, 1000 posts Feste Award Nominee! Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 465336  
Subject: Deficit spending, NOT QE, moves the market Date: 4/11/2013 10:04 PM
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Cullen Roche over at Pragmatic Capitalism has an interesting post today: [1]


I often have people ask me:

“Why does QE make stock prices go higher if there’s no fundamental impact?”

My answer is always the same. First, look at Europe where QE has also been implemented and stock markets like Greece, Italy and Spain have been decimated. Then look at a country like the USA where QE has been implemented and yet stocks soar. Then ask yourself what the big difference is between these countries? The answer: austerity versus massive deficit spending.

It might be easy to scoff at such an observation, but the reality of the picture is that corporate profits have been largely driven by the deficit in this cycle. As net investment collapsed the traditional driver of profits was overtaken by government spending (see figure 1). This makes sense if you’re familiar with Kalecki and his profits equation. It makes even more sense if you’d been working under Richard Koo’s balance sheet recession theory in recent years. The impact of government deficit spending in such an environment has been massive. All those people screaming about the ill effects of deficit spending and hyperinflation in recent years missed the very explainable and fundamental driver of the profits momentum.



I recommend you at least take a brief look at the two charts he included. One chart shows the dramatic level of government spending and its contribution to corporate profits. As you are probably aware, corporate profits as a percentage of GDP are close to an all time high. This is one of the main arguments by Hussman, Grantham etc that corporate profits will revert to the mean and fall as a percentage of GDP. The presumption is when profits fall, stock prices will fall also.

The second graph shows corporate profits and the value of the SP 500. I sure wish the dollars were on a log scale which would show the proportions better. Putting them on a linear scale like this tends to make you think that both the SP and profits are growing exponentially, like a “meltup” when in fact, it will be closer to a linear, more rationale rate.

Understand that when the SP is rising faster than earnings, it means that the PE ratio is increasing. Starting in 1996, the PE ratio headed to the stratosphere.

The other observation forms the basis of Cullen’s opinion. Since the earnings bottomed in 2009, they have been up strongly, roughly doubling from $800 billion to $1.6 trillion. The SP has followed suit, which roughly keeps the PE ratio constant. Cullen’s belief is that this dramatic increase in profits is largely due to government deficit spending and is largely responsible for increasing stock prices.

I don’t think we have to worry about it, but it does beg the question:

What if austerity took hold and the government substantially reduced the annual deficit on short order? Would corporate profits necessarily fall and take the stock market down?

If you believe Cullen’s theory and assume deficit spending is here to stay, you SHOULD remain bullish on the market. Obviously, this is contradictory to Hussman etc.

You get to vote each and every day by setting your portfolio allocation.

Thanks,

Yodaorange

[1] Pragmatic Capitalism Chart of the Day: Corporate Profits vs. the S&P 500
http://pragcap.com/chart-of-the-day-corporate-profits-vs-the...
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