Secretary of Defense Chuck Hagel dropped a bomb yesterday, outlining a five-year budget proposal that would shrink the U.S. Army to levels not seen since the beginning of World War II. The announcement unleashed a predictable chorus of outrage, along with warnings that America has entered a long, slow decline.
Perhaps. But let’s cut to the real question that traders are probably asking themselves: what does this mean for the stock market? Funny you should ask. There’s some economic research on precisely this subject. And it suggests that what Hagel is proposing could pay some dividends.
In 2008, three economists -– William R. DiPietro, Emmanuel Anoruo and Bansi Sawhney -– published in article in which they tested the relationship between military spending and the stock market in the U.S. and U.K. between 1914 and 2001. The authors used a sophisticated econometric technique known as the Bierens and Guo unit root procedure (read more here if you must) to run an advanced form of regression analysis.
Economists have been divided on the question of whether military spending is “good” for the economy. Some have argued that modern capitalism can’t survive without it; others have argued that whatever their contributions to boosting aggregate demand, defense outlays crowd out spending in other areas, funneling capital to less productive arenas of the economy that otherwise wouldn't attract investment.
But misallocations aside, the stock market could well benefit from increased military spending -– or so these economists hypothesized. Their number-crunching confirmed this, suggesting a rather robust positive correlation between increased per-capita military spending and stock market performance, with a 1 percent increase in defense spending per capita correlated with a bump in the Dow Jones Industrial Average that ranged from .55 percent to 1.91 percent. Data from the U.K. delivered similar, though less dramatic results.
So Hagel’s proposal to cut the military spells trouble for the stock market, right? Actually, no. The headlines about plans to reduce the size of the Army by 6 percent obscured the news that, over the coming years, the actual level of defense spending is set to rise slowly, from $535 billion in 2016 to $559 billion in 2019. And that’s before members of Congress move to shelter their districts’ pet projects.
In fact, what most analysts have missed is that the reduction is strictly in the number of active personnel, not overall military expenditures. Hagel wants to cut the number of people in the Army from its post- Sept. 11 high of 570,000 to somewhere around 440,000.
And that, too, may be a boon to the stock market. DiPietro and his colleagues found that the number of military personnel per capita has historically been negatively correlated with stock market performance. In other words, mustering more people is bad news for the stock market, with corresponding drops in the Dow Jones Index between 1.75 percent and 2.39 percent. Cut the number of military personnel, and in theory you may eliminate that effect.
Hagel is effectively laying out policies that may boost the stock market in two ways. He plans to increase military expenditures, however slowly. His proposal would simultaneously cut the economic drag of a more labor-intensive military.
All of this is probably good news for the stock market. Whether it’s a good military strategy is, of course, another question altogether.
To contact the author on this story:
Stephen Mihm at firstname.lastname@example.org