The Shrinking Deficit: a Plus for the Market

The federal deficit is projected by the Congressional Budget Office to be just under $500 billion this fiscal year (the year ending Sept. 30, 2014). (See http://www.cnbc.com/id/101581648.) That's a lot of money, but only one-third the deficit of five years ago.  In other words, the deficit is lower by a trillion dollars, compared to half a decade ago.  That's a whopping huge drop, which leaves this year's deficit at 2.8% of GDP, below its historical norm of 3%.

When deficits fall, the government competes less in the credit markets against private sector borrowers.  This makes it easier for private interests to secure investment capital, a key predicate to economic growth.

Stocks tend to rise during periods of falling federal deficits.  The late 1940s and the 1950s are one example.  The 1990s are another.  The fact that stocks have risen steadily from their 2009 lows indicates that we are in another period of falling deficits and rising stocks. 

The future direction of the deficit is unclear.  The CBO predicts that it will fall a bit more next year and then begin to rise.  However, five years ago CBO didn't come close to predicting the deficit reduction we now have.  The weird, dysfunctional cognitive dissonance that is today's federal governance somehow managed to produce this beneficial result.  Who knows whether it might stumble its way to more good outcomes.  If the deficit stays moderate (near 3%), the markets will probably benefit.  While there are many other factors fueling volatility today, the federal deficit, improbably, isn't one of them.

When the Market Will Go Down Next

With the stock market having more than doubled since its 2009 low, the question on the table--just about every investor's table--is when will the market turn down?  Recent trading days give us a likely answer.

For the past three trading days, the market dropped sharply as momentum stocks had bad momentum days.  Today, the market rallied briskly when the Federal Reserve released notes of its most recent open market committee meeting, indicating that central bank accommodation is alive and well.  Sweeter words could not have fallen on the market's ears, and stocks rejoiced.

As long as the market has confidence in central banks, there won't be a major downturn.  If the market senses that central banks are losing control, watch out.  Corporate earnings matter for individual stocks.  But central banking is the key to the overall direction of the market.