Market Rallies Don’t Always Make Sense

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Can government infrastructure spending, or “fiscal stimulus,” create more wealth? The stock market certainly seems to think so. As financial publications have recently opined, the stock market has been hitting record highs (Dow 20,000!), at least partly because investors believe the new Administration will usher in an era of government spending on things like roads, bridges, telecommunications and defense. While this may give some companies a boost, it will be a drag on long-term economic growth.

The Seen Versus the Unseen

The art of economic thinking is always to consider the seen versus the unseen. In the case of infrastructure spending, what is seen is the widening of highways, the new suspension bridges and the faster internet cables being buried underground. It is easy to see how this spending could be a good thing because the wider highways and faster internet probably enhance productivity.

Furthermore, any government spending – even on bridges to nowhere – is seen as beneficial, due to the Keynesian idea of the “multiplier effect.” This theory posits that governmental spending gives the construction workers more income, who then go and spend the income on other goods and services such as restaurants or new cars.

This in turn gives those restaurant staff and car manufacturers more income, which they then promptly spend. Each dollar the government spends is therefore “multiplied” throughout the economy.  

The Unseen Hand

What is missing from this analysis is the unseen. For government to spend any money, it must first get that money from somewhere; taxes are the most direct method and borrowing is another option, but this only means higher taxes in the future to pay for the borrowing.

While the government technically can’t print money directly to finance spending, it can do so through other means, which cause inflation and which are – you guessed it – just another form of tax.

Therefore, since taxes can only be taken from those who are creating wealth (for example taxes on profits or income), or from the existing base of wealth (such as real estate taxes), then by definition, government spending can only be accomplished through the transfer of wealth.

But Isn’t Infrastructure Useful?

Proponents of government spending may agree there is a transfer of wealth occurring, but that wealth is being employed into productive uses, such as infrastructure. After all, the construction and maintenance of roads allows businesses to ship their goods all over the country more easily.

It is true that things like roads, bridges and electrical grids are useful. But the pertinent question is how useful? If money is taxed away from a business to build a road, that business may no longer be able to build another manufacturing plant and provide an increasing number of products at a lower price, employing more workers in the process.

In other words, infrastructure spending faces a calculation problem. While politicians can hazard a guess that a wider highway or a public transportation project has some value, it is impossible to know (or prove) that the project is more valuable than what the private sector would have spent those tax dollars on.

If this calculation problem were enough to give cause for concern, there is also a problem of incentives. Infrastructure projects that are likely to be funded are those that will create the most jobs or please the most constituents, not the ones that make the most economic sense.

This logic means that the Keynesian “multiplier effect” does not exist, because every dollar spent to begin with does not come out of thin air but must instead be redirected from something productive. In fact, some of the latest rigorous academic research has confirmed the government spending multiplier to be negative, not positive (see a nice summary of this research from Dr. Lacy Hunt of Hoisington Management).

Employee IncentiveWhat this Means for the Stock Market

The stock market is always forward-looking, and it is likely making new highs for a host of reasons on which financial journalists can only speculate. It is also true that increased fiscal spending could give select companies a lot of extra business in the short term.

However, valuation levels for broad market indices such as the S&P 500 are currently at some of the highest levels in history, exceeded only during the dot-com bubble and the brief run-up before the Great Depression. At current levels, the stock market would have to decline by anywhere from 40% to 60% just to return to historical norms!

To be clear, valuation tools are not timing indicators, and anything is possible in the short term, including a continued bull market in the months ahead. However, what valuation models of the stock market can reveal is that, over the longer-term (10-12 years), investors should expect very low returns (low single digits annually) if they invest at these elevated levels.

Diversify across All Asset Classes

The best strategy is to stick with a plan of being diversified across asset classes, including hard assets such as precious metals, other commodities and real estate.

And don’t let any infrastructure spending plans fool you into thinking it will be a huge boost for the economy and the stock market!