Elon Musk's cost-saving plan could trigger a bear market in U.S. stocks!

Source: Jin10 Data

Senior media analyst Mark Hulbert stated that stock market investors hope the Department of Efficiency (DOGE) will significantly reduce the U.S. budget deficit, but this is not necessarily good news for them.

This is because there is a close correlation between the budget deficit as a percentage of U.S. GDP and corporate profit margins. A substantial reduction in the budget deficit will almost certainly lead to a corresponding sharp decline in corporate profit margins.

This could be very bearish for the stock market, as its recent bull run has been primarily built on expanding profits. All else being equal, if the operating profit margin of the S&P 500 does not stay above the average of the past 30 years (7.37%) and instead remains at the estimated 11.88% for 2024 (which is not yet finalized for Q4 earnings), the index would have to fall by 38%.

The chart below shows the year-over-year changes in the S&P 500 operating profit margin and the share of the budget deficit in U.S. GDP. The correlation is remarkable.

Vincent Deluard, Global Macro Strategist at StoneX Group, recently highlighted this correlation in a report.

As Deluard explained, “Public accounting requires that the public sector’s deficit equals the private sector’s surplus. When the government spends a trillion dollars on green infrastructure, data centers, or vaccines, private companies and workers ultimately cash that check… U.S. growth and profit margins have been unusually high because the U.S. government has maintained a 7% deficit four years after the pandemic ended.”

What if the government spending cuts by DOGE are actually wasteful and inefficient? Would that be beneficial for the overall economy, especially corporate profits?

Deluard agrees but warns that the economic benefits of cutting wasteful government spending will only become apparent in the long term, while the short-term impact on corporate profits is bearish.

“Releasing these resources (by eliminating wasteful spending) to the private sector could promote long-term prosperity, but it will definitely harm short-term growth. Paying government workers to dig holes and fill them at night can boost GDP and private profits — and vice versa,” he explained.

Cutting wasteful government spending is an admirable goal. However, investors should not ignore the relationship between the public deficit and private profits. Notably, Deluard predicts a bear market in the U.S. stock market later this year.