…after all, the only way the US will achieve budget balance will be through some combination of higher taxes and lower government spending.  The former will mean less income available for consumption; the latter will mean less stimulus from Washington for the economy.  On the surface, at least, both imply slower economic growth for some years–something that should be bad for stocks.

Yes, that’s right.  But it’s not the whole story.

For one thing, half the profits of the S&P 500 come from operations outside the US.  Their growth shouldn’t be negatively affected to any great degree, if at all.  Professional will tilt their portfolios toward foreign earners.

There’s also the question of the price earnings multiple applied to corporate profits, which in the case of the S&P 500 is currently relatively low.  Arguably, there are two reasons for this–both based on the idea that ordinary investors are much more savvy than pundits think.

1.  The current situation with government spending and taxation is economically unhealthy and ultimately unsustainable.  If deficit spending proceeds unchecked, some point lenders will lose confidence in the ability of the US to repay its obligations and demand, at a minimum, higher interest rates on new loans.  A two percentage point rise on $14 trillion in debt–which would come only slowly, as existing debt matured–would add about a quarter-trillion dollars to government debt servicing expense! And that’s by no means the ugliest thing that could happen (look back to the government bond buyers strike in 1987, for example).

Maybe the market PE would be 10% higher if the US weren’t slowly headed down this road.

2.  In investors’  imaginations fiscal contraction is almost certainly worse than the reality will be.  It’s even possible that more highly taxed citizens will demand better service from Washington than we get at present–maybe immigration reform to allow highly skilled foreign students to remain in the US, maybe shrinking the military so it’s not Washington’s largest expense, maybe finding out why Americans pay 2x what the rest of the world does for the same healthcare.  Who knows?  In any event, the elimination of uncertainty may be worth another point–or more–on the PE multiple.

In essence, I’m arguing that a reversal of bad fiscal policy won’t be a Wall Street disaster because the assumption of a continuation of that slow-motion train wreck is already depressing equity prices.  I don’t think, on the other hand, that prices will explode upward if Washington changes stripes.  A mild uptrend, with growth stocks outperforming?  Maybe Generations X and Y will begin to invest to fund their retirements…