Since we last looked at the S&P 500's expected trailing twelve-month earnings per share some three months ago, the future for the S&P 500's forecast earnings has become considerably brighter going forward. Which is good, because it also suggests that the U.S. economy went through a recessionary period in the second half of 2012, from which investors are now expecting a recovery.

We can see that's the case in comparing our 15 February 2013 snapshot of the S&P 500's expected trailing year dividends per share for the fourth quarter of 2013 (2013-Q4, ending 31 December 2013) with our new snapshot just taken on 17 May 2013:

Here, for 2013-Q4, we see that investors have increased the level of earnings they expect to be reported for the S&P 500 in 2013 by $7.47 per share from our previous snapshot taken just over three months ago, with the new trailing twelve month figure now expected to be $108.18 per share.

This is close to the level that investors had first expected for 2013-Q4 back on 17 January 2012. But then, back in those heady days, they also expected that the earnings for the S&P 500 in 2012 would be $12.80 per share better than the $86.51 per share that they actually turned out to be. (Note: Standard and Poor may continue to revise its earnings estimate for 2012 for some time still as more refined information becomes available and as companies might restate their previously reported earnings.)

Looking at the full range of values that investors have forecast for the S&P 500's trailing year earnings for 2012, we see that they have ranged from a high of $100.07 per share, which was recorded back on 20 May 2012, to a low of $86.51 per share, as currently estimated. The low value of $86.51 per share also would appear to mark the bottom of an earnings recession for the index.

So why didn't stock prices crash at the same time? Well, as we keep pointing out, earnings don't drive stock prices. Dividends do. And although this confuses many of the more dim-witted commenters at Seeking Alpha, the changes that have taken place in dividends since mid-November 2012 are almost entirely responsible for the rally in stock prices since that time. Or at least up to nearly the end of April 2013, after which the story changes.

But we don't expect that certain people will appreciate that we've already told that story, and don't feel compelled to dumb it down for their benefit....

Reference

Silverblatt, Howard. S&P Indices Market Attribute Series. S&P 500 Monthly Performance Data. S&P 500 Earnings and Estimate Report. [Excel Spreadsheet]. Last Updated 9 May 2013. Accessed 17 May 2013.

You have to admit - we were right. Last week was indeed a big week for the S&P 500!

From Monday, 13 May 2013 to Friday, 17 May 2013, the S&P 500 rose by nearly 2%, or 32.35 points, from 1630.77 to a new record high of 1666.12. Over half the gain for the week came on Friday, 17 May 2013, as the S&P 500 rocketed up by 17 points.

In doing that, the S&P 500 completed the transition it began on 1 May 2013, as investors shifted their forward-looking focus from the second quarter of 2013 to the first quarter of 2014 in setting their expectations for the sustainable portion of future earnings growth for the stock market (a.k.a. "future dividend growth".) We can observe this transition directly in our chart below as the movement of the daily and 20-day moving average of the change in the rate of growth of stock prices from the red line representing 2013-Q2 to the green line representing 2014-Q1, which correspond to the change in the year-over-year rates of growth of the trailing year dividends per share expected for each of these quarters.

Now, even though this confuses the more dim-witted among Seeking Alpha's commenters, this latest transition of investor forward-looking focus from 2013-Q2 to 2014-Q4 follows very similar transitions that have taken place periodically since the end of the Federal Reserve's QE 2.0 program at the end of June 2011. Following the deflation of that mini-bubble in the weeks that followed, stock prices have since been very fundamentally-driven with little noisy exception, with the pace of acceleration of stock prices matching up with the changes in the growth rates of trailing year dividends per share for discrete future quarters.

The transitions of investor forward-looking focus from one future quarter to another, combined with changes in the growth rate of dividends expected in quarters where investors have focused their attention, accounts for nearly all but a small portion of the changes in stock prices that have occurred in the post-QE 2.0 period.

These periods of transition in forward-looking focus also mark the greatest uncertainty we have in anticipating the direction and change of stock prices over time, outside of significant noise events such as the Federal Reserve's quantitative easing programs marking major changes in their acquisition rates of U.S. Treasuries. That was definitely the case with QE 2.0, when the Fed ramped up then discontinued an interest-rate lowering bond-buying program, which resulted in the mini-bubble for stock prices.

However, that has not been the case with QE 3.0, where the Fed ramped up only its purchases of Mortgage Backed Securities in September 2012, or for QE 4.0, which began in December 2012, where the Fed maintained its ongoing acquisition rate of U.S. Treasuries that it set in its "Operation Twist", but stopped selling off an equal value of holdings that was the other part of that operation. The lack of change in the Fed's basic acquisition rate of U.S. Treasuries for both QE 3.0 and QE 4.0 is why these latest quantitative easing programs have had no significant impact upon stock prices.

Now that the pace of acceleration of daily stock prices has risen above the green line on our chart above, we can expect the recent rate of growth to taper off, and even to fall following this period of transition, as there is no fundamental support for stock prices to remain significantly above this level for any sustained period of time, absent some action by the Fed.

That brings us to this week, where a lot of focus will be upon the pronouncements of the Federal Reserve. At present, there are a number of indications of recessionary conditions being present in the U.S. economy, which the Fed might attempt to offset by amping up its purchases of U.S. Treasuries. The market's response to such a noise event would be the only reason for the latest rally in stock prices to continue at their current rapid pace of escalation, as the earnings season for the second quarter of 2012 is nearly over, leaving little time left for corporate earnings announcements and changes in dividend policies to affect stock prices.

Speaking of which let's take a closer look at that microtrend rally. Our following chart shows the upward rise of stock prices since 15 November 2013, nearly one month before the Fed began its QE 4.0 program, with respect to the S&P 500's trailing year dividends per share:

We mark the beginning of the newest microtrend rally in stock prices from 1 May 2013, which coincides with the divergence of stock prices from the level that is defined by the dividends that are expected to be paid by the end of 2013-Q2. The new microtrend rally is characterized by an even more rapid escalation rate for stock prices than seen in the period from 15 November through 30 April 2013, which is also something that we associate with transition periods in where investors set their forward-looking expectations.

We'll take a closer look at the longer trend in stock prices later this week....

Late in 2011, after realizing that Spain had run up an exceptionally large budget deficit for the year, exceeding 8.5% of the nation's entire GDP, the newly elected government of Mariano Rajoy set out to get Spain's fiscal situation under control.

To do that, Rajoy committed Spain to a program of spending cuts and tax hikes in 2012, as demanded by the European Commission (EC). A program that appears to have only succeeded in crashing Spain's troubled economy in 2012. (Refresh the image below to see Spain's quarterly GDP growth rates from 2010 through the end of 2012.)

But which aspect of Rajoy's austerity program is most responsible for sinking Spain's fortunes? Was it the spending cuts? Or was it the tax rate hikes?

Believe it or not, we can answer that question! And to do it, we'll use data from the United States for its fiscal multipliers!

What's a fiscal multiplier, you ask? A fiscal multiplier is a ratio that tells us how much a nation's income, or GDP, is affected by changes in its government's spending or taxation policies. They are typically used by economists to predict how much more or less economic activity there will be in an economy as a result of a change in the levels of government spending or taxation.

That's where the data from the U.S. comes into play, because we'll use the fiscal multipliers that have been calculated for both government spending and for taxes to apply to Spain's situation in 2012 to see if we can predict how much Spain's GDP was affected by the different parts of its so-called austerity program.

Let's start with the government spending multiplier. Research published by the Federal Reserve in January 2013 finds that the fiscal multiplier for government spending is somewhere between +0.6 and +0.7, which applies when unemployment rates are high (above 7.5%).

Here, having a fiscal multiplier with a value of less than 1 means that changes in government spending have a muted impact on a nation's GDP. For a fiscal multiplier of 0.6 to 0.7, if government spending were increased by 1 billion dollars, the nation's GDP would only rise by somewhere between 600 to 700 million dollars. Likewise, if government spending were cut by $1 billion, GDP would only fall by $600-$700 million.

By contrast, the tax multiplier has a much greater impact on GDP. Here, Christina Romer and David Romer (Christina Romer was formerly the chair of President Obama's Council of Economic Advisers, which is oddly omitted from her official academic biography) have found that the fiscal multiplier that applies for taxes is approximately -3.0, which as you notice, is both rather large in magnitude and negative.

What being large in magnitude means is that changes in tax levels will have an outsized effect upon GDP. What being negative means is that is changes in a nation's tax policy have an opposite effect upon its GDP. So, for example, if a nation were to cut its taxes by 1 billion dollars, it could expect to see its GDP grow by 3 billion dollars. Conversely, if a nation were to hike its taxes by $1 billion, it would expect to see its GDP fall by $3 billion.

Now let's apply these multipliers to Spain's situation in 2012. Starting with the spending cuts, we find in using data from Eurostat along with GDP reported in the World Economic Outlook for 2013 that Spain's spending was $668.8 billion (in terms of U.S. dollars) in 2011 and $635.5 billion in 2012, as Spain cut its spending from the previous year by $33.3 billion.

The tax data is more difficult to come by, because here, we must use the estimated amounts by which Spain's government expected to increase its revenue by increasing its tax rates and through other means. We do this because while a nation has full control over how much it spends, there is no guarantee that it will actually be able to collect as much revenue as it expects or plans, especially as those being taxed often make adjustments to avoid the full burden of new or higher taxes being imposed upon them.

Early in 2012, the Rajoy government imposed higher taxes on both wage and salary income as well as investment income, expecting to increase its tax collections by 4.3% over the $528.2 billion USD it collected in 2011, or rather, by approximately $22.71 billion USD. In addition, the Rajoy government also planned to crack down on Spain's tax evaders, expecting to collect an additional 8.2 billion euros ($10.67 billion USD) through their increased enforcement measures.

However, by September 2012, it was clear that these measures would not be sufficient to close Spain's budget gap as much as the European Commission demanded. As the EC threatened to end its bailout of the Spanish government as Spain's debt crisis escalated, Rajoy's government finally consented to also increase Spain's value added tax rate, which took effect after September. This measure was expected to increase Spain's tax collections by an annual amount of 7.5 billion euros ($9.8 billion USD), but for our purposes, this tax increase only applied in the final quarter of 2012, so the expected additional tax collections from this source in 2012 is one-fourth that amount, or $2.45 billion USD.

Adding all those government revenue increasing amounts that apply for 2012 together gives us a total of $35.82 billion, for which the tax multiplier of -3 will apply.

We'll take these values and enter them in our tool below, which will do the fiscal multiplier math!

In the tool above, we used the lower end of the range of possible values that would apply for the government spending multiplier in obtaining the result using our default data of a GDP decline of $127.5 billion for Spain, which would be predicted using the Spanish government's actual level of spending cuts and our static analysis-produced expected increase in Spain's revenues from the government's tax-hiking frenzy in 2012.

The actual value that Spain's GDP fell in 2012 from 2011's level was $127.5 billion. The fiscal multipliers that seem to apply in the United States would therefore appear to be very effective in predicting how much other nation's GDPs might change in response to changes in their government's fiscal policies.

We should note at this point that these figures are likely to be revised in the future, which means that the actual fiscal multipliers that apply in Spain may need to be tweaked from this preliminary analysis. Which is, of course, why we made it very easy to alter them in our tool above!

Consequently, we find that the Spanish government's attempt to increase its revenues, driven by the EC's demands to impose higher taxes on Spanish businesses and high income-earning individuals, is responsible for about 84% of the nation's decline in GDP, while its spending cuts were only responsible for 16% of the decline in Spain's national income from 2011 to 2012.

And that is a prime example of austerity done wrong.

References

Knoema. World Economic Outlook, April 2013. [Online Database]. Accessed 15 May 2013.

Knoema. World Economic Outlook, April 2013. GDP per Capita - Spain. Accessed 15 May 2013.

Knoema. World Economic Outlook, April 2013. GDP - Spain. Accessed 15 May 2013.

Eurostat. Government Finance Statistics. [Online Database]. Accessed 15 May 2013.

Owyang, Michael T., Ramey, Valerie A. and Zubairy, Sarah. Are Government Spending Multipliers Greater During Periods of Slack? Evidence from 20th Century Historical Data. [PDF Document]. Federal Reserve Bank of St. Louis, Economic Research Division. Working Paper 2013-004A. January 2013.

Romer, Christina and Romer, David. The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks. [PDF document]. March 2007.

LibreMercado. The government shuffle a new tax increase to reduce the deficit. [Google Translation]. 20 August 2012.

EuroNews. Spanish VAT Rise: A Backward Plunge. 6 September 2012. Accessed 15 May 2013.

Angloinfo. Tax Rises in Spain for 2012. January 2012. Accessed 15 May 2013.

Image Credits

Trading Economics. Spain GDP Growth Rates. Accessed 16 May 2013.

Ryan, Rebecca. The Multiplier Effect of Local Investing. Lion Investing. 20 February 2011.

Ammons, David. Income tax on high-wage earners? WA Secretary of State Blogs: From Our Corner. 21 April 2010.

Ammons, David. House D Budget: Cuts, delays, but no sales tax hike. WA Secretary of State Blogs: From Our Corner. 21 February 2012.

In 2012, after Spain's government had run up an extraordinary budget deficit in the previous year, the newly elected government of Spain's new prime minister, Mariano Rajoy, committed to both increase the government's revenue and to decrease its spending to put the Spain on a more sound financial footing. Those changes had been demanded by the European Central Bank as a requirement for its continuing to lend money to bail out Spain's fiscally distressed government, which had been put at risk by its bailout of that nation's banks following the collapse of the Spanish housing bubble.

To help put Spain's fiscal situation going into 2012 into context, we're presenting an updated version of the chart we first featured nearly a year ago when we first examined how Spain arrived at that state. The chart shows the relationship between Spain's GDP per capita and its annual government tax collections and expenditures per capita for each year from 2000 through 2011:

Today, we're going to focus on the revenue side of what happened in Spain in 2012, using data just published within the past month. Starting with Spain's 2012 GDP per capita of $29,288.70 (in terms of U.S. dollars), let's first see how much the Spanish government could have hoped to collect in revenue for that level of GDP if they had kept the same tax rates as Spain had from 2000 through 2011:

Using our tool with Spain's data, we find that if Spain made no changes in its tax rates, the Spanish government could have expected to collect the equivalent of $10,556.48 USD per capita, given its actual 2012 GDP per capita figure. We'll revisit this estimate, based upon Spain's non-economic bubble-related government revenue figures from 2000 to 2003 and 2009 through 2011, shortly....

Now, let's consider just what Spain did with its tax rates in 2012. The Wall Street Journal's Real Time Brussels blog reports:

Soon after it took office, the new government of Prime Minister Mariano Rajoy raised income taxes to curb a swelling budget deficit. We have written before that the by-now conventional wisdom, supported by the International Monetary Fund and others, is that cutting government spending is a more effective way to squeeze budget deficits than raising taxes. Mr. Rajoy's right-leaning government nonetheless chose to raise taxes "temporarily," apparently because it was viewed as socially more equitable than the alternatives.

The tax increases, write Spanish economists Juan Ramón Rallo, Ángel Martín Oro and Adrià Pérez Martí in a paper published today for the free-market Cato Institute, have left Spaniards paying among the highest income tax rates in Europe.

Our second chart shows how Spain's individual income tax rates changed from 2011 to 2012, which should result in increasing the nation's tax collections by anywhere from 3.0% to 13.5%, depending upon income bracket, where high income earners face much more dramatic tax hikes:

In addition, Spain also increased its tax rates on investment income from 19% to 21% (for investment income under 6,000 Euros), and from 21% to either 25% or 27%, with the higher rate applying on investment income greater than 24,000 Euros). These taxes should have increased the Spanish government's revenue from taxes on investment income by anywhere from 9.5% to 22.2%.

Later in 2012, Spain also implemented a surprise rate hike in its value-added tax, from 18% to 21%, which would be sufficient increase the government's take from this source of revenue by 16.7%.

So the range of increases in the government's revenue from these various taxes runs from 3.0% to 22.2%, with the actual net increase in the government's tax collections then depending largely upon the distribution of income in Spain. As you can see from the very progressive nature of most of these tax hikes, the government of Mariano Rajoy went very much out of its way to impose higher taxes on high income earning individuals as part of the "tax the rich" portion of its deficit reduction strategy. And in fact, the Rajoy government predicted that it would collect 4.3% more revenue than the Spanish government collected in 2011.

That 4.3% increase over its 2011 collections would have given Spain an expected tax revenue of $11,943.94 USD per capita for 2012.

Our final chart reveals how 2012 actually played out for those expectations:

In 2012, Spain's government revenue per capita was actually $10,661.09 USD. Only $104.61 more per person than our estimate of what would be reasonably expected if Spain had not hiked its taxes at all given how Spain's economy performed during the year.

Given the magnitude of the tax hikes that Spain targeted to most affect the country's highest income earners, what this outcome demonstrates is Hauser's Law at work in Spain. Once a government has maximized its revenue collecting capability, it is unable to change how much it collects by imposing higher and higher tax rates on its highest income earning citizens, who generally respond to the increased tax burden placed upon them by no longer generating the same economic activity they did when they were subject to lower tax rates.

That has major consequences, as these individuals are the most capable of generating the kind of economic activity that grows a nation's GDP. Without any ability to affect the European Union's monetary policy to offset the negative effects of Spain's contractionary fiscal policy, Spain paid a very large price to learn that lesson the hard way, as the country became a highly undesirable place to invest time, effort or money for its most productive residents and businesses. Consequently, Spain's economy has crashed to the point where it might reasonably be considered to be in a full economic depression in 2012, which is where it still stands today.

All in all, a pretty clear example of austerity done wrong.

Previously on Political Calculations

• The Greek Budget Identity (2012)
• Spain: A Very Different Fiscal Crisis (2012)
• President Obama's Unsustainable Fiscal Path (2012)
• Austerity, Done Right, Part 1 (2012)
• Austerity, Done Right, Part 2 (2012)
• Hauser's Law (2009)
• Is Hauser's Law Still Valid? (2011)
• Taxes at the Margin (2012)
• Hauser's Law at Work Today (2012)

And then, suddenly, the future for the S&P 500 snapped into clear focus:

It would appear that investors have shifted their forward-looking focus to 2014-Q1 in setting the pace of change for U.S. stock prices. Following the period after the fiscal cliff reaction of 15 November through 20 December 2012, they had been focused mainly on 2013-Q2.

Now that the transition in focus from 2013-Q2 to 2014-Q1 seems assured, we can expect the recent rapid run-up of stock prices to taper off, as the change in the growth rate of stock prices will converge with that expected for the S&P 500's dividends per share in 2014-Q1. Since that pace is positive, we can expect stock prices to continue generally rising, although at a slower pace.

However, anything that might shift the focus of investors to the less distant future quarters of 2013-Q3 or Q4 will send stock prices crashing.

Other factors that might cause the acceleration rate of stock prices to deviate from the 2014-Q1's expected trailing year dividends per share are the Fed's quantitative easing (QE) policies, where the Fed has recently indicated it could amp up its purchases of U.S. Treasuries or could begin tapering them off altogether. Beyond that, random noise events could temporarily send stock prices off track.

From our perspective, perhaps the most surprising thing about the rally in the stock market since 15 November 2012 is that it has been extremely driven by underlying fundamentals. The one thing that ended the recent uncertainty we had in which alternate future investors would select to focus their forward-looking attention upon was the sudden decline in the 2014-Q1's expected dividends per share, which dropped from $9.37 per share to $9.11 per share on Monday, 13 May 2013 - coinciding with the end of the period for establishing the shareholders of record for the biggest two stocks in the S&P 500, Apple and Exxon Mobil.

That change brought the level of the change for the growth rate of expected trailing year dividends per share into easy reach for today's stock prices. With that being the case, they are more likely to be able to hold that level outside changes in the Fed's QE policies, which if the Fed is targeting stock prices as it has in the past, means that they can get away with doing less as there is a fundamental reason for stock prices to continue growing.