A Stock Market Positioned To Win A Battle Of Sentiments: Taxation Versus Economic Optimism

On August 20, 2015, I wrote “A Broad and Bearish Breakdown for the Stock Market” that described a converging set of indicators which flagged short-term bearish conditions in the stock market. The post happened to precede the August, 2015 flash crash by two trading days. It was one of those moments when the technicals worked exactly as a technician would hope (although I was also a bit early in playing a bounce from oversold conditions).

One of those bearish indicators was the amount of U.S. Federal taxation as a percentage of GDP. At that time, this percentage was at levels last seen in 2000 which meant it surpassed the peak from the last bull cycle. This level of taxation seemed destined to suck liquidity out the economy that might otherwise be used to pump up the stock market. Over a year later, it now looks to me that the timing of seeing this chart just ahead of the August flash crash was kind of a “happy” coincidence. The chart below is current through the third quarter of 2016 (the vertical axis, on the left, is percentage).

The level of Federal taxation relative to GDP peaked last year.

Source: US. Bureau of Economic Analysis, Federal government current tax receipts [W006RC1Q027SBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; December 10, 2016.

The S&P 500 (SPY) is now at new all-time highs and has managed to spend most of the year trading well above the sell-off levels from August, 2015.

The S&P 500 accelerated into fresh all-time highs during the past week.

Source: StockCharts.com

The index has maintained these lofty levels even as the percentage of GDP going to Federal taxes has stabilized around last year’s peak. This apparent contradiction of the liquidity thesis suggests to me that there is little use in trying to anticipate the kind of peak in the percentage of taxation that precedes a recession and/or a major sell-off for stocks. Indeed, I think it makes more sense to wait for this percentage to experience a sharp drop before using it as part of a bearish case. Of course, by the time these data come available, it may be too late to do react in a meaningful way. Stay tuned.