When Big Ben Speaks, You Should Listen

By wyatti@bfpublishing.com (Ian Wyatt),

Shutterstock photo

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 forward.

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 ( GS ) 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 stimulus... " 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 loans.

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 eye on?

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 stocks.

***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 recovery.

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 perfect stock.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing Stocks
Referenced Stocks: GS

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