US public debt growth and equity market performance are inextricably related. Naturally so, because debt finances growth and, in turn, the growth of the earnings of the public companies allows them to distribute dividends that investors can reinvest by buying the stocks of the companies. This is a normal process in capitalism and part of how a free market economy works. Is this a Ponzi scheme, as some people have called it, especially when companies use their earnings to buy back their stock and push prices higher?
My position is that the stock market is not a Ponzi, as long as the debt growth is in line with productivity growth. But if we are going to look at the system from a macroeconomic perspective, we will be lost in definitions, models, and even politics, philosophy, and ideology. Instead, we will look at the data and try to infer associations. This is tricky because causality is an ill-defined concept. In reality, causality of any form can be dismissed or even considered naïve. But some associations are striking and cannot be ignored.
Since 1900, the annualized return of the S&P 500 index has been 2.4%, inflation-adjusted. But after dividend reinvestment, it has been 6.6%. Without the reinvestment of dividends, the returns of the market would not justify passive index investing. Most pension funds have large allocations to stocks. They are the main source of funds that drive stock market uptrends. Without pension money, it is highly unlikely the US stock market would have realized the returns it has over the years. Let us look at another chart that shows the growth of US public debt and the S&P 500 index.
Before we start trying to decode the message of this chart, I have to clarify the following: Two-axis charts can be highly misleading when used to prove correlations. Instead, here we try to show an association. The chart shows a relatively smooth rise in public debt and a not-so-smooth rise in the S&P 500, which is still persistent. First, we notice that the 12-quarter rate of change (ROC) of the public debt peaked in the mid-1980s. During that time, some economists and government officials started to raise concerns about the growing debt. The US federal government managed to balance the budget by 2001. Note how the 12-quarter ROC of the public debt fell to its lowest-ever level around 2001. Also, note the top of the S&P 500 index and its 12-quarter ROC. One of the worst bear markets in the history of the stock market occurred between 2000 and 2002. Notice how the public debt line (black) on the top chart turned nearly flat by the 2000 top formation.
As soon as the stock market started plunging, the debt began to grow again. That facilitated the uptrend between 2002 and 2007 in the S&P 500 index. Then, due to the financial crisis of 2007–2008, the stock market plunged again. By then, it was clear that the market needed support from the central bank. Pensions were already linked to the market. Earnings were on the decline, and the impact of dividends on real returns started to decrease. The system needed growth stocks with the potential to make up for the loss of dividend growth. That required a huge boost in spending and rising public debt. But rating agencies started issuing warnings. Therefore, the debt grew, but then the 12-quarter ROC stayed flat until the 2020 pandemic when it started growing again after receiving another boost.
The pandemic white swan accelerated debt growth, but the supply shock and war in Europe drove inflation to high levels, and stocks fell. The debt kept rising to facilitate high nominal growth in stock prices and prevent a devastating bear market. The plan worked, but in the last two years, the S&P 500 return has been less than 1% and, on a total return basis, less than 4%. This means that without a further boost in debt, it will be hard for the stock market to rise higher, and another correction may commence.
Some claim the public debt level is not important as long as the US dollar is a reserve currency. Is there any limit to public debt beyond which a crisis will start? A debt crisis will push bond yields to high levels, possibly above 10%, and make stocks unattractive. The impact on pension funds will be devastating due to the crashing bond market. One way to deal with this ominous scenario is to start another technological revolution. In the 1990s, it was the “information highway” that led to the world wide web growth as the new economic engine. The new attempt centers around artificial intelligence, but this comes with the risk of increased unemployment and non-linear second-order effects that are not clearly understood. Whereas the World Wide Web increased productivity, created many new jobs, and facilitated the growth of online business, artificial intelligence may have a reverse effect with high unemployment and job growth only in a few specialized fields. But it seems this is the only alternative now before another explosion of public debt is needed to sustain stock market prices.
The next two years will be crucial for the economy, the stock market, and worldwide financial stability. Can artificial intelligence come to the rescue of free markets? If not, another balancing of the budget will be required to avert a financial crisis, and the first victim will be the stock market.
My opinion is that the system is at the edges of complexity, both financial and technological, but also geopolitical if we are to extend the dimensions. Mathematically speaking, these types of highly non-linear systems may lack what are called heteroclinic orbits, which are the orbits that allow transitioning from one stable equilibrium point to another. Let me say this: if this system lacks a heteroclinic orbit, we are all screwed. The collapse will be monumental—nothing we have ever seen before, not even 1929. A new system will have to be invented and implemented. This is what the crypto and bitcoin proponents argue. However, the system they propose is probably as complex as the current system, if not more. Therefore, I cannot envision any viable solutions in the event that the current system has no stable regions. I only hope something new will be invented—something we now do not understand but is waiting to reveal itself at the right moment. Maybe I am an optimist, but that is the only way.