How the Federal Reserve’s Reduced Outlook Will Impact the Stock Market

Federal Reserve’s Reduced OutlookBy its words and actions, the Federal Reserve has made it pretty clear that the U.S. economy is not getting better. The central bank cut its gross domestic product (GDP) estimate for this year and near-zero interest rates are not supporting the creation of new employment opportunities. Despite what the Federal Reserve says, it doesn’t have much left to stimulate the economy; the business cycle has to run its own course, and that means that the U.S. economy will be very vulnerable going into 2013.

If you’re a stock market investor, the reduced outlook for GDP obviously makes it more difficult for corporations to grow their earnings. What’s remarkable is just how well the stock market is holding up considering the dismal outlook just presented by the Federal Reserve. I suspect that positive anticipation regarding second-quarter earnings season and a reasonable stock market valuation are what’s keeping things together. As soon as corporations start saying that business is starting to slow, the stock market will go lower.

The Federal Reserve has basically done all it can to appease the stock market, and this makes the market increasingly vulnerable going forward. The collective actions of the Federal Reserve are inflationary, and it will come to haunt the stock market and the economy. Accordingly, investors should plan for more inflation-friendly assets over the next several years. However, the U.S. economy is likely to experience another technical recession beforehand, as I don’t see how GDP can accelerate with all the problems in the eurozone and with slowing economic growth in China.

Quite simply, the U.S. economy (with a major portion being real estate) got overleveraged and the correction in the business cycle requires more time to balance out. The Federal Reserve is basically powerless to re-inflate the bubble that it and other policy makers created. So, it’s continued mediocrity for the near future.

This is why a conservative investment stance is warranted in the stock market and why higher dividend paying stocks are outperforming. (See “With Emerging Market Slowing, Corporate Earnings Are the Key.”) You might not be able to get strong earnings growth, but you can get that income, and most importantly, there’s no other asset class offering the ability to earn above the inflation rate. There are many large-cap, higher dividend paying stocks that are currently trading right at their 52-week highs for this very reason.

The Federal Reserve still might implement some form of QE3 once second-quarter GDP data comes available. But whatever the central bank does, it really won’t help the U.S. economy accelerate; it has to do this on its own.