Weekly Market Commentary 7-30-12

The Bureau of Economic Analysis has officially confirmed that the economy has downshifted from 4.1% growth to 1.5% growth in the first half of the year. The Dow Jones Industrial Average rallied almost 200 points on Friday in hopes that the Fed will act to address this downfall.

Based on this news, I see a few scenarios that could happen for the remainder of the year:

1) The economy continues to “muddle through” with weak growth rates but does not slip into a recession, and the Fed does nothing. In order for the economy to have negative GDP growth, consumer spending would have to drop by approximately 166 billion dollars. This is probably unlikely because consumers have plenty of revolving credit and savings to fuel buying. On the other hand, we also know consumer spending isn’t growing because wages aren’t growing. Under this scenario, the market reaction would likely be negative as many participants have already priced in additional action by the Federal Reserve.

2) Our economy slips into a recession, the Federal Reserve can act forcefully, and the market reacts positively because of the wealth effect. I have written about the wealth effect and what the Fed can and can't do before here. Remember, the wealth effect is an economic term, referring to an increase (decrease) in spending that accompanies an increase (decrease) in perceived wealth. Some studies suggest a $1 increase in equity values raises consumption by 5 to 15 cents—not a bad thing for the Fed to bet on when they have fairly limited tools.

3) The economy turns on a dime back up to 4.1% GDP growth. Overall I don’t think this outcome is very likely, but here are some catalysts to spur business and consumer spending:

• Stable fiscal and tax policy
• More jobs
• Improved consumer confidence, enough to take on more debt
• Return to growth in the Euro Zone
• Emerging market economies return to 8%+ growth

If we were to speculate, I think the most likely scenarios are one or two. The good news for us is we don’t need to pick one, because speculation doesn’t matter in the long run. At times speculation can make for good conversations, but it never makes for good investment advice.

As you can see from the table below from John C. Bogle, CEO of the Vanguard Group, the market had an average return of 10.4% over the 20^th century, and 9.8% of the return was driven by dividends and earnings growth. Only 0.6% of the return was driven from speculating.