Three Factors Influencing Market Direction

July 28, 2010By: Ian WyattArticles RSS feedPrintPrint

Small-cap stocks tend to trade in tandem with the broader market. And while their gains and losses tend to be greater than those for large cap stocks, there is no doubting the direct correlation between macro-economic trends and stock market returns.

Accordingly, it's always important to keep an eye on macro-economic themes to help gauge market direction and overall sentiment. Because at the end of the day, these issues can, and will, affect your stock picks.

After the financial crisis many things changed. One thing that's become clear is that large banks are getting bigger and bigger. The largest banks in the market have gained more U.S. deposits and are dominating all banking segments - from checking accounts to mortgages.

According to financial research firm SNL Financial, J.P. Morgan (NYSE: JPM), Wells Fargo (NYSE: WFC), and Bank of America (NYSE: BAC) had a combined 21 percent of all U.S. deposits in mid 2007. Today these banks have 33 percent of all deposits. This 12 percentage-point increase in total deposits was the fastest shift of bank deposits in U.S. history.

To put this massive shift in perspective check out the chart below, it shows the increase in U.S. deposits at the three largest banks in America over the last 11 years.

The end result of this change is that the largest banks now have a ton of market power - and smaller banks continue to shut down in a slumping economy. Throw Citigroup (NYSE: C) into the mix and in March, these four banks had $7.7 trillion in loans and other assets. That's an increase of 56 percent since the end of 2007.


Looking at it from a different angle, the combined assets of these 4 banks are almost twice as big as the next 46 largest banks, according to data from SNL Financial.

So what do the experts say about this shift in power to larger financial institutions?

Arnold Danielson, a bank analyst in Bethesda, Md., says these mega-banks "can make money beyond belief…there is no chance of anyone challenging them".

The downside is that if these banks stop lending, cash flow to consumers could dry up. And that has begun to happen. In the first quarter of this year, loans outstanding at U.S. banks with over $100 billion in assets declined 1.5 percent. This decline was 3 times greater than banks with assets of less than $100 million.

If these banks hold the lion's share of U.S. deposits and their lending is slowing, it's reasonable to assume that cash flow to consumers will slow. With fewer places to get loans, the economic recovery will largely depend on what these banks decide to do - and when they decide to do it.

Increased lending would help the economy recover at a faster rate, which would in turn have a positive effect on the broad stock market. Currently, these banks are not comfortable lending money to anyone off the street (as they did before the financial crisis). So I wouldn't expect the market to shoot higher without bank lending.

You should also be aware of what's going on in Washington. Last Thursday, Treasury Secretary Timothy Geithner said the Obama Administration will allow tax cuts for the wealthiest Americans to expire at the end of the year.

Even if you aren't in the wealthiest bracket, the increase in the marginal tax rate for people earning more than $250,000 will affect the economy, the market, and you.

Three Senate Democrats have already come forward and expressed an interest to extend the tax cuts. Democratic Senator Evan Bayh said raising the tax rate on the wealthy "...runs the risk of dampening consumer demand at a time when that is critical to recovery". Other democrats said "...it probably is too soon to cut spending or raise taxes..." and that "...it's important for members to remember the top 5 percent [of earners] generates 30 percent of consumer spending".

With such a large percentage of spending coming from the wealthiest people at a time of tremendous uncertainty, the general argument is that tax rates should not increase until the economy shows more signs of improvement.

The last thing the economy needs is another factor that will limit spending, and stall growth in the process.

Finally, a change that may have a more direct effect on investments is the decision to allow the capital-gains tax cuts to expire at the end of this year. If the Obama administration increases capital-gains taxes investors may decide to sell stocks and take gains at the lower tax rate. This could prevent the market from moving higher.

More specifically, this increase in capital-gains taxes could have a greater impact on growth stocks, many of which are small-caps. More large companies are value stocks - these tend to pay a dividend - while smaller companies usually reinvest their proceeds back into the company. These are growth companies.

Since dividend income is taxed at the marginal tax rate (and not as capital gains) value stocks will look increasingly attractive, at the expense of growth stocks. If the capital-gains tax increases, investors may be more inclined to put money in value stocks that pay a dividend.

Investors tend to look to large cap companies when seeking out dividends - but if the capital-gains rate increases be sure to check out value stocks in the small cap asset class as well.

These are just a few macro-economic themes to keep an eye on.
All these issues relate to the general health of the economy - and small-cap stocks will follow the direction of the broad market.

This article originally appeared on SmallCapInvestor.

Ian Wyatt
Chief Investment Strategist, Wyatt Investment Research
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