Last Friday there were a few developments that hinted at the
current state of the US economy. If the economy recovers at a
slower pace, it will adversely affect the stock market and thus,
your returns. So understanding these developments, and the
potential impact, is important as we consider market risk moving
There was a fresh sign on Friday that the economic recovery in
the US is still sluggish. The Commerce Department revised its
second-quarter estimate of GDP growth saying the US grew at 1.6
percent in the previous quarter - down from the original estimate
of 2.4 percent. Sure, a large increase in imports contributed to
the decline, but any revised number lower is never good.
Over the last few weeks, investors have become increasingly
worried about the chances of a double-dip recession. Economists at
Goldman Sachs (
have one of the most pessimistic outlooks, estimating the
likelihood of a recession at 30 percent.
However, these negative GDP results were overpowered by the
Fed's announcement on Friday that it is ready to act if the economy
continues to falter. Investors responded to the good news as the
Dow jumped 165 points, or 1.65 percent before the weekend.
Fed Chairman 'Big Ben' said,
"...policy options are available to provide additional
" if the economy continues to struggle in coming months.
At the top of the Fed's list is its ability to purchase
long-term securities, a move that would likely drive long-term
interest rates even lower. Looking at the chart below, the Fed
can't do much with short-term rates, as they've already been pushed
down to near zero. When you hear people talking about short-term
rates, they're almost always referring to the federal funds rate -
this is the interest rate banks charge each other for overnight
The Fed also has the option of lowering the interest rate it
charges banks to hold their funds. This would make it cheaper for
banks, which are still lending at a minimum.
The final option is to increase the inflation target rate to 2
percent, up from its current target rate of 1.5 percent. Increasing
the target rate would allow for greater economic output, which
could in turn help the economy recover at a faster rate.
These are just a few of the top options the Fed can use if
economic conditions worsen.
***Some experts, like Economist Joseph Stiglitz, are worried
that the US could suffer from economic stagnation like that which
engulfed Japan in the 1990s. Stiglitz says, "
There are many ways in which you can see [the US] almost surely
being in a Japan-style malaise
But what does this mean for you and what should you keep your
The Fed's moves in coming months should shed light on the
strength of the economic recovery. Remember, small-cap stocks tend
to outperform the rest of the market during an economic recovery -
we don't exactly know which way the economy will move, but my money
is on a slow recovery.
Take a look at the relative performance of small, mid, and large
cap stocks since the beginning of the year and you'll see that that
the returns are fairly similar, with smaller stocks outperforming
by not decreasing in value.
Will small-caps stay even with the rest of the market or will
they outperform in coming months?
If the economy recovers small-caps should outperform. As
investors become more confident in the economy, they will shift to
riskier investments (i.e. small-caps), which would drive shares
higher. Naturally, the fundamentals of these companies need to
support stock price appreciation.
Coming out of a recession small-caps tend to outperform since
they have greater exposure to growth. And with their smaller market
caps increases in sales normally translates to greater percentage
increases in share price. We've seen this occur over the last
12-months, as per the chart below. Small and mid-mid cap stocks are
up around 50 percent, versus around 35 percent for large cap
***I'd pay close attention to the Fed's meetings over the next
few months. This week key data will be released that should give
investors a snapshot of the economy and where it's headed.
The Consumer Confidence report will be released this morning and
can help predict shifts in consumption patterns. And remember,
we're a consumer driven economy (despite the decrease in spending),
so greater confidence can lead to greater consumption and a quicker
Employment data should hint at the current conditions of the
labor market and will be released Friday morning. Employment should
be one of the key contributors to the recovery, both because
greater employment should decrease government liabilities like
unemployment benefits and because an employed populace should help
GDP grow. Stocks would likely follow.
Understanding these macro-economic developments should help you
understand market risk - and accordingly the risks your investments
face. There is always stock specific risk, so don't think that you
can relax on your equity research for a minute. But sometimes
understanding the bigger picture is more important than finding the