Elon Musk's cost-cutting plan could trigger a U.S. stock market bear trend!

Source: Jintuo Data

A veteran media commentator, Mark Hulbert, said that stock market investors hope the Department of Government Efficiency (DOGE) will significantly reduce the United States’ budget deficit, but that is not necessarily good news for them.

That’s because there is a close correlation between the budget deficit as a share of U.S. GDP and a company’s profit margin. A large reduction in government deficits will almost certainly lead to a correspondingly large decline in corporate profit margins.

This could be very bearish for the stock market, since the bull market in recent years has been built largely on ever-expanding profits. With everything else unchanged, if the S&P 500’s Operating Profit Margin were not above the average level of the past 30 years (7.37%), but instead at the level estimated for 2024 (11.88%)—given that the earnings for Q4 2024 have not been finalized—then the index would have to fall by 38%.

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

In a recent report, StoneX Group’s global macro strategist Vincent Deluard highlighted this correlation.

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

What if the government spending that DOGE cuts really is wasteful and inefficient? Would that definitely benefit the overall economy, especially corporate profit margins?

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

“Releasing these resources (by eliminating wasteful spending) to the private sector may promote long-term prosperity, but it certainly hurts near-term growth. Paying government workers to dig holes and fill them in at night can increase GDP and private profits—and the reverse is also true.” he explained.

Cutting wasteful government spending is a commendable goal. But investors should not turn a blind eye to the relationship between public deficits and private profits. Notably, Deluard predicts that the U.S. stock market will see a bear market later this year.