We're Nearing the Debt Top

04/28/2011 9:00 am EST

Focus: MARKETS

Timothy Lutts

Publisher, Cabot Heritage Corporation

Deficit reduction is now a widely shared priority, and the era of lean government may be just beginning, with explosive implications for the stock market, writes Timothy Lutts, chief investment strategist of Cabot Wealth Advisory.

I'm a big fan of long-term trends.

It’s valuable to know that trends, once in motion, tend to persist longer and run further than most investors expect. It's also valuable to know that a trend, once ended, will give way to a new long-lasting trend in the other direction.

For example, the housing market began collapsing in 2007. That was 43 months ago, and the statistics from the housing industry are still terrible.

But when a 60-year trend ends, that's what you get.

The good news, however, is that the collapse of the housing bubble was just the first in a long line of dominoes that have begun the process of bringing our balance sheets back to rational levels.

  • First, it encouraged—or forced—consumers to reduce their levels of borrowing. And they did so fairly quickly, generally within a year.
  • Second, within two to three years, reduced economic activity and shrinking tax revenues forced cities, towns, and even states to institute their own austerity programs.
  • And now, the biggest player of all—our own federal government—has finally begun knuckling under to these forces that can be ignored no longer. The ship of state has turned.

Barack Obama has now publicly acknowledged the value of addressing our huge deficit. Democrats and Republicans are arguing over how much the deficit should be cut. And over in the corner, the Tea Party is quietly celebrating the fact that its competitors have adopted its cause.

The day-to-day machinations are interesting to some observers, but to me, the long trend is the real story.

In fact, I believe this is just the beginning of a trend that will run a generation or more, resulting in debt reduced to levels that are currently unimaginable.

To understand my thinking, consider a little history.

The Way We Were
In 1913, the 16th Amendment to the Constitution established the federal income tax. In that year, total receipts were $714 million. Total outlays were $715 million. The national debt was $2.9 billion.

The national debt then ballooned to $27.4 billion (a ten-fold increase), largely because of World War I.

It was wrestled back down to $16.2 billion (a 41% reduction) at the end of the Roaring Twenties, partly courtesy of Calvin Coolidge, who as a Republican with Federalist leanings thought states should do the heavy lifting in government.

But it was soon climbing again—and fast—as Franklin Roosevelt used federal money to fund programs designed to end the Great Depression.

By 1940, the national debt was $43 billion. And it's been growing ever since!

NEXT: Why This Can’t Go On

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Why This Can’t Go On
So what makes me think this uptrend will end soon?

Well, for one, this chart looks a lot like the charts of famous stocks that have topped out in spectacular fashion.

chart
Click to Enlarge

But more importantly, it appears that people and politicians are finally beginning to accept that this debt has become an albatross around our neck—and not just because Standard & Poor's recently downgraded our national debt.

They're beginning to recognize that if we don't reduce our debt voluntarily, our creditors might show up one day (just as they do to homeowners), and ask for their assets back. And they're taking concrete steps to reduce our annual deficit and slow the growth of our national debt—and eventually reverse it—to generally put our balance sheets in order. [Lutts wrote about the federal deficit reduction panel’s proposals late last year—Editor.]

So Calvin Coolidge, from one perspective, represented the last gasp of a "small government" movement (by 1927, only the richest 2% of taxpayers paid any federal income tax!), while FDR marked the beginning of a "big government" movement that lasted 78 years.

But I believe that trend was nearing its end when even pro-business Republicans, like George Bush, saw no problem with increasing our debt. And it reached its extreme with the TARP bailouts and the Cash for Clunkers program.

Note that these inflection points were accompanied by first, the Great Depression, and second, the Great Recession. It takes a big shock to change the prevailing attitudes and behaviors of the American public.

Now forces are pushing the pendulum the other way.

Of course, there won't be a steady change. There will be starts and stops, grand achievements and major setbacks, and that is normal. Most people will not even recognize that the new trend is in place.

But I can tell you that investors love improved balance sheets. And I can speculate that after a decade in which the stock market has made no progress, it is ripe for a broad renewed uptrend, and the growing perception that our fiscal house might finally be put in order could be a real tonic to that effect.

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